Question

In my upcoming Finance exam, I might have to compare 2 projects (Make vs Buy) with the NPV rule. Initial investment amounts, pre tax cash inflows, pre tax cash outflows, WACC and tax rate are given. How do I have to deal with depreciation in both cases (Make and Buy)? Normally, I deduct the annual depreciation from the net cash flow (pre-tax) to determine EBT, then Tax CF and ultimately find the after tax Net CF. Do I have to apply any given depreciation here for both options (Make vs. Buy) just as usual? TIA

Answer 1

Effect of depreciation for BUY decision making Under NPV calculation

The basic thing about NPV that it stands on the foot of cash flows. Depreciation is not a cash flow so when stream of cash flows are calculated the depreciation is not considered.

The use of depreciation in the NPV calculation is that it reduces the tax amount and acts as a tax shield.

Suppose the net sales of the firm is $100000 and the tax rate is 30%

Therefore the taxable amount is $30000

From the taxable amount depreciation is deducted and so it acts as means of tax savings.

In the buy decision of any asset when we check the NPV of such buying we use the depreciation for reducing the tax liability of the investor.

In case of MAKE decision making

In this case the relevant costs and irrelevant costs are required to be considered.

Once the equipment is purchased for the production of a particular item no other cost related to that equipment will be considered while calculating total cost of the production as such cost is called sunken cost. Depreciation is charged on tangible assets. Therefore depreciation should be charged on the equipment but here it is not a relevant cost. It is the sunken cost in respect of the particular item.

Now if we apply the NPV technique and need to find out the present value of the series of cash outflows (Assume that the finished goods will be produced after 3 years) we have to determine the present value of total costs that excludes depreciation. So present value has no connection with the outflow money.

In case of finding out inflow of cash the relevant cash flows are considered.

Here depreciation is required to be considered to compute the tax liability of the firm.

(we have to consider depreciation as an expenses in order to deduct it from revenue to find out the EBT on which tax rate is charged)

Suppose the revenue of the firm is $100

Depreciation is $25 and other costs are $35

Therefore, the net income before tax is $100‐($25+$35)

= $40

Tax rate is 30%

So the tax amount is $12

the net income of the firm is $40‐$12 = $28

Cash flow of the firm is net income + non cash cost = $28+$25 = $53

Therefore to find out the cash inflow of the firm the depreciation amount is deducted from the cash flow amount in order to calculate the tax liability. Once the net income is prepared the depreciation amount is added back to ascertain the cash flows which are required NPV calculation.