a. Since depreciation is a cash expense, the faster an asset is depreciated, the

Question

a. Since depreciation is a cash expense, the faster an asset is depreciated, the lower the projected NPV from investing in the asset.

b. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer.

c. Corporations must use the same depreciation method for both stockholder reporting and tax purposes.

d. Using accelerated depreciation rather than straight line normally has the effect of speeding up cash flows and thus increasing a project's forecasted NPV.

e. Using accelerated depreciation rather than straight line normally has no effect on a project's total projected cash flows nor would it affect the timing of those cash flows or the resulting NPV of the project.

Explanation / Answer

Answer (a):

Depreciation is the reduction in the value of asset. Suppose you have a machine used in your production. The use of machine will rduce its value. This reduction in value should be a part of cost of production since without the use of machine capacity production is not possible. Hence depreciation amount is debited in the revenue statement.

But depreciation is not a cash expenses. No cash outflow is required when depreciation is charged. Actually by charging depreciation, a portion of net profit is kept aside. It is like a reseve fund. It is used as internal fund until the existing machine becomes unusable and new machine is purchased.

As no cash flow is required, it is added with net revenue to get correct cash inflow. You know that Net present value is the discounted value of future cash flows. It converts future money inflows into current money value. Sum of the present values of future cash flows are added to get gross present value. From this value initial outflow is deducted to get net present value.

Thus net present value depends upon cash flows which remains unaffected by the depreciation amount. However depreciation is considered as eligible item of expenses for income tax computation. So it will help the firm to reduce income tax and increase cash flow. If you depreciate at faster rate, then cash flow of the intial years will increase due to this low tax benefit. You know that present value of cash flow of intial years are higher than the present value of cash flows of ending years. Hence projected NPV will be increase.

Thus it is wrong to say that due to faster depreciation of asset NPV will fall as it is a cash expense. Rather NPV will increae. It will not increase as depreciation is cash expense. Rather depreciation is a non cash expense. Increase in NPV will be due to higher tax benefit available in the initial year.

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Answer of part (b):

Depreciation can be charged by using different methods. In straight line method equal amount of depreciation is charged in each year. Another method is rducing balance method. Here a certain percentage of depreciation is charged on the begining balance. Thus initially depreciation charged is high. Then it gradually decreaaes as it becomes old.

Any one of these method can be applied. Objective will be to select a method which is most appropriate under existing circumstances. Once a method is used it should be consistently followed in the coming years. Change is permitted if sufficient reason exists to ensure that such change will give true and correct view of the revenue of the concern.

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Answer of point (c):

In point (c) it has been stated that Corporations must use the same depreciation method for both stock holder reporting and tax purpose. This statement is not true. It has the right ton use different methods for corporate reporting and tax purpose. Even it can use different depreciation method for different class of assets. But once a method has been used for a particular class of asset, it should be consistently followed for all assets of that class. Further once a particular method is adopted in first year of the running of business, it should be consistently adopted for coming years also.

However ther should be appropriate notes on the methods of depreciation followed with suitable logic in the reported statement for adequate disclosure.

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Answer of part (d)

Use of accelerated depreciation will increase NPV. In this system, depeciation charged in the first year will be maximum. Then gradually it will decrease.

Note that depreciation does not mean cash outflow. So due to higher amount of depreciation, cash fllows of the inttial year will not afffect directly. Indirectly it will get affected due to tax benefit. Depreciation is deducted as expenses for computing taxable income. Hence higher depreciation will lower taxable income. So tax paid will be low. As tax is saved cash inflow will increase. Thus accelerated depreciation will help in increasing cash inflows of the initial years.

You know that time value effect is less on initial years and more on latter years. Bigger the time gap between current period and cash inflow year less will be the present value of cash flows. Thus higher cash inflows in the intial years under accelerated depreciation method will help in increasing NPV.

So whatever stated in point (d) in the problem is true. Use of accelerated depreciation has the effect of speeding up cash flows in the initial years. It will ultimately increase project forecasted cash flow.

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Answer of point (e):

Extending the discussions of point (d) it can be said that statement (e) is wrong. It states no effect of the use of accelerated method over straight line method on projects total cash flow and NPV.

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