Question

Should depreciation be considered in capital budgeting?

A: No, because it is not a cash expense.

B: Yes, because accounting rules require asset depreciation.

C Yes, because it changes EBIT, which is a cash outflow.

D: Yes, because it changes tax liabilities, which are a cash outflow.

Answer 1

Option D is correct - Yes because it changes tax liabilities, which are cash outflow

Depreciation is a non cash expense but while calculating Income Tax we deduct depreciation to get pre tax profit

Depreciation expense reduces the pre tax profit therefore we have to pay less tax, (in other words depreciation results in a depreciation tax shield which helps in reduction of tax liabilities)

Therefore we should consider depreciation in capital budgeting decisions because it changes tax liabilities which are cash outflows