BUS 5111 - Week 2 - Discussion Assignment PDF

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Download BUS 5111 - Week 2 - Discussion Assignment PDF

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The impact of depreciation expense on the cash flow analysis of a capital project. Depreciation is an important concept in capital projects, because depreciation is a non-cash expense and ideally should not have any effect on the cash flows. For that reason, it is added back during the cash flow calculations, since the cash never left the company’s bank account. So, prima facie, it may appear like depreciation had no effect whatsoever. First, the amount was deducted while calculating the net income in the income statement, then the same amount was added back while calculating the cash flows, basically nullifying the effect. However, depreciation affects cash flows in an indirect manner. (Juneja) Depreciation is a non-cash expense; however, it is tax deductible. This means that the amount of depreciation a company pays, affects the amount of taxes payable. While calculating net income the depreciation and amortization figure is removed from EBIDTA to arrive at Profit before Tax. This is the amount on which tax is levied and the company get the Profit after Tax figure. (Juneja) In effect, the higher the depreciation amount, the lower the taxable profit will be and as a result the lower the tax amount payable will be. Therefore, depreciation indirectly affects the cash flow by reducing the amount of taxes paid and a high depreciation may have a positive impact on the cash flows. (Juneja) The amount of tax that were reduced because of depreciation can be calculated and is known as the depreciation tax shield. With Depreciation

Without Depreciation

EBIDTA

$2000

$2000

Depreciation

$500

$0

PBT

$1500

$2000

Tax @ 40%

$600

$800

PAT

$900

$1200

According to the calculations above, when depreciation is considered the tax paid is lower by $200. This $200 is the tax shield. However, entire calculation needs to be done to come up with the amount of the tax shield. Simplifying the calculation, we can consider that for every $1 we have in depreciation we have saved $0.40 in taxes. To find out the amount of the tax shield we need to multiply the amount of total depreciation by the ongoing tax rate. I.e. $500 X 0.40 = $200. (Juneja) Accelerated depreciation methods will provide a higher tax shield upfront as compared to straight line methods. When discounting these tax shields, the concept of time value of money applies. For this reason that accelerated method of depreciation is preferred to straight line methods. (Juneja) The implications of a leasing arrangement on depreciation expense. An operating lease is treated like renting. The lease payments are considered as operating expenses. Assets being leased are not recorded on the company's balance sheet. They are expensed on the income statement which affects both operating and net income. (Tardi, 2019) On the other hand, a capital lease is like a long-term loan or ownership. The asset is treated as being owned by the lessee (company) and is recorded on the balance sheet. Capital leases are counted as debt, depreciate over time and incur interest expense. (Hayes, 2019) Accrual accounting allows for the inclusion of certain economic events, a capital lease is an example of these events. A company is required to calculate the present value of an obligation on its financial statements. For example, if the present value of the obligation under a capital lease is $100,000, the company then records a $100,000 debit entry to the corresponding fixed asset account and a $100,000 credit entry to the capital lease liability account on its balance sheet. (Hayes, 2019)

Because a capital lease is a financing arrangement, the company must break down the periodic lease payments into interest expenses based on the applicable interest rate and depreciation expense. If the company makes $1,000 in monthly lease payments and the estimated interest is $200, this produces a $1,000 credit entry to the cash account, a $200 debit entry to the interest expense account and an $800 debit entry to the capital lease liability account. (Hayes, 2019) The leased asset must also be depreciated factoring in its salvage value and useful life. For example, if the above-mentioned asset has a 10-year useful life and no salvage value based on the straight-line basis depreciation method, the company records an $833 monthly debit entry to the depreciation expense account and a credit entry to the accumulated depreciation account. When the company disposes of the leased asset, the fixed asset is credited and the accumulated depreciation account is debited for the remaining balances. (Hayes, 2019) As mentioned previously, the depreciation expense accounted for decreases the tax payable by the company.

References Juneja, P. (n.d.). MSG Management Study Guide. Retrieved from https://www.managementstudyguide.com/capital-budgeting-and-depreciation.htm Tardi, C. (2019, September 8). Operating Lease Explained. Retrieved from https://www.investopedia.com/terms/o/operatinglease.asp Hayes, A. (2019, September 9). What You Need to Know About Capital Leases. Retrieved from https://www.investopedia.com/terms/c/capitallease.asp...