Question

The are two main reasons why we need to specifically deal with depreciation in the capital budgeting analysis. State and briefly describe both of them.

Answer 1

Answer :

Depreciation is very important and crucial in capital budgeting decision due to following 2 reasons:

1.) Depreciation is non cash Item : The amount of Depreciation is not paid like any other expense . It is the amount of expenses which results in no outflow of cash , therefore it needs to be specially seen while estimating incremental cash flows of Project.

2.) Depreciation saves tax : Depreciation , though non cash expense results in saving as it is tax deductible expense.So in this way depreciation affets the cash flows in indirect manner. Depreciation affects the amount of taxes which are paid . Depreciation indirectly affects the cash flow by decresing amount of taxes paid & will have a positive impact on the cash flows.