Question

When estimating the incremental cash flow at T=0, we have to include: The cost of the...

When estimating the incremental cash flow at T=0, we have to include:

  • The cost of the investment.
  • The cost of any modifications.
  • The cost of delivery and set up.
  • Any net investment in working capital that results (plus or minus).

All of these except the last one is included in the original capitalized value and depreciated over the economic life of the project, but the last one (even though it is still an investment at T=0) is not depreciated.

Why the difference?

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Homework Answers

Answer #1

Only capital assets are eligible for depreciation. Capital assets are those which give benefits / generate cash flows over multiple time periods. Hence, they are not expensed in the year of purchase, but a portion of their cost is expensed each year over their life. This is the concept of depreciation. The depreciable cost of the capital asset includes the purchase price set-up cost, installation cost, delivery cost etc.

The net investment in working capital is not a capital asset, hence it is not depreciated. It is simply a cash outflow due to investment in working capital (inventory, spare parts, accounts receivable etc.), which is recovered at the end of the project's life. These are not capital assets, and cannot be depreciated.

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