Question

Cash flow development for capital budgeting projects requires the inclusion of all cash inflows and cash outflows associated with a new project. Depreciation, while recognized as a non-cash expense, is included in the cash flow development.

a.) Why is depreciation included in developing cash flows for a capital budgeting project?

b.) Which category (or categories) of cash flow development would depreciation be included? (List each category where depreciation is part of the cash flow development and explain why depreciation is included in that category.)

Answer 1

a: Depreciation is a non cash expene and so it is added back to be included in the cash flows for capital budgeting. It is only an accounting entry and not an actual expense.

b: Depreciation is added back to Net Income to arrive at operating cash flows from a project. First we begin with Revenues - costs to arrive at income. Thereafter we reduce taxes to arrive at net income after tax. Then depreciation is added back to arrive at operating cash flows. This is required to incorporate the tax shield of depreciation while adding back depreciation to cash flows.