Question

Which of the following statements is true about depreciation and cash flows?

(a)Depreciation does not affect cash flow, and therefore must be added back to pre-tax income

(b)Depreciation is a cash outflow that reduces accounting income

(c) Accelerated depreciation methods will increase a project’s net present value

(d)Accelerated depreciation methods will increase cash outflows closer to present

Answer 1

Depreciation is a non cash charge, it is therefore added back to the pre tax income.

FCFF(FREE CASH FLOW TO THE FIRM) = EBIT - TAXES + DEPRECIATION - CHANGE WORKING CAPITAL - FIXED CAPITAL EXPENDITURE.

Accelerated depreciation will increase a project's NPV, as a higher depreciation expense in the initial years will result in a higher ,the higher the tax shield, so there will less cash outflow for the payment of taxes. Hence, the NPV will be higher.

The NPV will be higher, by recognising higher depreciation expense in the early years.

The correct options are a and c.