Question

What is depreciation in the capital budgeting process? Why is it important to consider? How is it calculated? What property/assets can be depreciated? What is the relationship between depreciat ing an asset, and the terminal value of the asset?

Answer 1

What is depreciation in the capital budgeting process?

The yearly depreciation expense from writing off a firm's plant and equipment is an example of an expense that does not affect cash flow. Apart from tax consequences, all of the cash outflow associated with the purchase of any depreciable asset occurs when the asset is acquired. The asset is then expensed over its useful life. The concept of matching an expense with the future revenues created by that asset is referred to in accounting as the matching principle. In the analysis of the firm's investment decisions, we focus on the present value of the cash flows from capital investment projects, rather than on the matching of historic costs with future revenues. Consequently, our discussion will concentrate on determining the exact timing of future cash flows, with no explicit consideration (apart from the tax savings from the tax deduction for depreciation) to the matching of expenses with the cash flows which they generate.

Why is it important to consider?

Since the focus of our analysis is cash flow, the importance of depreciation expense arises from the fact that depreciation expense can be used to reduce future tax liabilities through the reduction of taxable income by an amount equal to depreciation expense. Depreciation expense reduces taxable income and the resulting tax liability without creating a “matching” cash outflow, cash flow is increased by the tax savings. In general, the cash flow or “tax shield” provided by depreciation expense is

                         Tax Shield from Depreciation     =     tc x Depreciation Expense

where tc is the corporate tax rate.  

                                    Cash Flow    =     ( 1 - tc ) x Revenue    +    tc x Depreciation

How is it calculated?

1.Annual Equivalent Cost :- We often need to estimate the yearly fixed cost associated with the use of a piece of equipment. For example, a meaningful estimate of the yearly fixed costs of manufacturing capacity is critical to determining the unit costs at a given level of production. To estimate the yearly fixed costs of production capacity, we need to determine the present value of the costs that must be recovered over the productive life (to be distinguished from depreciable life) of the machine. Given the present value of the costs that must be recovered, the annual equivalent cost is the level stream of costs (cash flows) having a present value equal to the present value of the cost of acquisition less the present value of the tax shields from depreciation.

      The present value of the costs that must be recovered over the productive life of an asset can be thought of in terms of

                        Purchase Price    -    Present Value of Tax Shields from Depreciation

In addition, we might also need to consider the tax savings from any investment tax credit associated with the purchase of the equipment, as well as the present value of any proceeds from selling the asset at the end of its useful life. These complications will be ignored for the moment.

2. Minimum Acceptable Rental Payments:- A problem closely related to the annual equivalent cost is the determining the minimum rental payment that a lessor must charge in leasing a piece of equipment to the final user (i.e., the lessee). Consider a piece of equipment which the lessor purchases for the sole purpose of leasing to the actual user. In order for the purchase of the equipment to be a positive net present value project, the lessor must require that the present value of the after-tax rental payments be equal to or greater than the present value of the costs associated with acquiring the asset. As the actual owner of the equipment, the lessor is allowed to deduct depreciation expense. The information in the previous example can be used to determine the minimum rental payment required to lease the equipment .

      Since rental payments are usually due in advance, the present value of the after-tax (for a lessor in a 40 percent tax bracket) rental payments over the next seven years would be

                                    ( 1 - .40 ) x Yearly Rent x [ 1 + ] .

Note that the term in brackets in the expression above represents the annuity factor for an annuity of 7 payments where the first payment is due immediately. That is the factor in brackets is equal to an immediate payment of one dollar plus the present value of a regular annuity of six payments.

What property/assets can be depreciated?

Depreciable property is any asset that is eligible for depreciation treatment in accordance with the Internal Revenue Service (IRS) rules. Depreciable property can include vehicles, real estate (except land), computers and office equipment, machinery, and heavy equipment. Depreciable property items are long-term assets.

What is the relationship between depreciating an asset, and the terminal value of the asset?

The terminal value method is an improvement over the net present value method of making capital investment decisions. Under this method, it is assumed that each of the future cash flows is immediately reinvested in another project at a certain (hurdle) rate of return until the termination of the project.

Depreciation is defined as the expensing of an asset involved in producing revenues throughout its useful life. Depreciation for accounting purposes refers the allocation of the cost of assets to periods in which the assets are used (depreciation with the matching of revenues to expenses principle).