Why depreciation is important in capital budgeting

Search for:. Key Takeaway Companies that pay income taxes must consider the impact income taxes have on cash flows for long-term investments, and make the necessary adjustments. Investment and working capital cash flows are not adjusted because these cash flows do not affect taxable income.

Revenue cash inflows and expense cash outflows are adjusted by multiplying the cash flow by 1 — tax rate. Although depreciation expense is not a cash outflow, it provides tax savings.

The tax savings is calculated by multiplying depreciation expense by the tax rate. Review Problem 8. Find the NPV of this investment using the format presented in Figure 8. Should the company purchase the machine? Money saved on taxes is cash that can be reinvested in the business, or taken out by the business owner. In general, the earlier you can realize the savings, the better, since cash today will have greater purchasing power and more investment potential than an equal sum years down the road.

Cam Merritt is a writer and editor specializing in business, personal finance and home design. By Cam Merritt. Method Straight-line depreciation involves reporting the same amount of depreciation expense each year.

Profit and Taxes Depreciation is simply an accounting tool, a way of spreading the cost of the equipment over its usable life. Cash Flow Business owners understand that in many ways, "profit" is just a number on paper. Depreciation on the buildings and equipment used in the project is computed and used to compute the tax liability. At the end of 10 years, the project ends.

Instead of ending the business, the equipment can be replaced at the end of the 10 years and the business continued. But for capital budgeting planning purposes at the beginning of the project, the year period provides a good assessment of economic viability. For example, the opportunity cost may be the rate of return the funds would have earned invested elsewhere.

If both equity and debt are used, the interest charged on the borrowed money and the opportunity cost rate of return may be blended in computing the discount rate. If it is, interest the cost of capital will be counted twice.

When creating a capital budget, it is important to allow for funds to provide adequate liquidity for operations. The amount of working capital remaining at the end of the project may not be the same as the working capital invested at the beginning of the project. A related issue is the capital needed to get the business project up and running.

In many situations, the time period from the initial purchase of equipment until the facility is completed and running at capacity can be long.

Funds are needed to bridge this time period. Another issue is working capital in the form of contingency funds needed to cover any unexpected occurrences.

Then we added the same amount back while calculating cash flows, thus nullifying its effect. However, there is more to depreciation. Depreciation affects cash flows in an indirect manner. The effect of the same has been described in this article. It is true that depreciation is a non cash expense. However depreciation is tax deductible. So the amount of depreciation we pay affects the amount of taxes we pay. This is the amount on which tax is levied and we get the Profit after Tax figure.