Question

Question 2 Rasha and Saced studying Managerial Finance were overheard in the library debating the treatment of depreciation in capital budgeting projects just before the exam. (2 marks) Rasha said:"You are wrong, depreclation is never included in project cash flows". However Saced responded with: "The formula sheet given by the lecturer for the exam includles depreciation expenses when calculating the project's after-tax cash flows" Write a clear and accurate response you would offer these two students to explain the appropriate treatment of depreciation for capital bodgeting purposes ACr

Answer 1

Depreciation is a non cash expense so it doesn't form part of project cash inflows and outflows however it is tax deductible expense.It means that depreciation reduces the amount of tax we required to pay.So we deduct depreciation only for the purpose of calculating tax.However it is added back to the project after tax cash flows to get back the true figure.

Rasha is partially correct depreciation is never included in project cash flows but it is included for the purpose of calculating amount of taxes to be paid.

Saeed is also partially correct depreciation is included in after tax cash flows but only where there is tax advantage due to taxes.