Question

When we immediately expense the capital investment instead of depreciating over time, how does this affect the Capital Budgeting problem ? Does it mean that the depreciation for this will be 0 and subtract the cost of the asset from the income ? Please help me in understanding how this works.

Answer 1

Firstly, we should expense the capital investment immediately because the investment requires outflow of cash immediately

Secondly, as depreciation is a non-cash expense, we need to subtract it to get EBIT and then subtract taxes to get EBIT*(1-tax rate) and then add back depreciation to get cash flow. In effect, depreciation provides a tax shield. ALternatively, we can add Depreciation*tax shield to EBITDA*(1-tax rate)

Now coming to your question, depreciaiton is not assumed zero and we are not subtracting the cost of asset from current income because income has not yet started and will only start after the investment has been made and after the project starts producing cash flows which may occur after a year or so.