Discuss the impact of depreciation expense has on the cash flow analysis of a capital project. Also discuss the implications of a leasing arrangement has on depreciation expense.
Impact of depreciation expense has on the cash flow analysis of a capital project
Depreciation is a non-cash accounting charge that does not impact direct impact on cash flow, although if a business produces sufficient taxable income, depreciation would reduce it as a tax-deductible expense and that would have a positive impact on cash flow by reducing tax(Investopedia, n.d.).
When a business purchases a long-term asset such as a car, furniture, real estate, computer, equipment etc. it can depreciate the value of it in future years, over the lifespan of the purchased asset.
An important point to remember, land can be part of a long-term asset, but it cannot be depreciated. The long-term asset is usually used to generate income in the long-term that is more than 12 months.
All fixed assets (except land) has a useful life, and business can depreciate the value over the useful life. Business can use “Straight line” method, Declining Balance or units of production approach to depreciating the value of the asset.
Before we go to depreciation, let us quickly see what happens when the business purchases the fixed asset –
The fixed asset can be purchased with the cash in hand, financed by bank or shareholders can loan the money to the business. So after purchasing the fixed asset, it will appear in the balance sheet as a fixed asset, and there might be a drop in cash in the balance sheet(if purchased with the cash in hand/ current asset) or there will be an increase in long-term liability.
Now coming back to how depreciation impacts cash flow –
Depreciation is not a cash outflow so it is added back to net income for each year until the value of the asset depreciates to 0.
For example, say I am a business owner and business needs a laptop. I loan my own money to the business, the laptop costs $1500. We can expect the laptop to be useful for 3 years. We expect the laptop to depreciate in a straight line, so $500 each year and it should generate enough income to cover for its cash. But when I say, depreciation is cash inflow, it is not 100% accurate. It is inflow over the useful life of the asset but there was outflow, the moment the business purchased the asset for $1500. So the inflow in form of depreciation just offsets the initial outflow. And usually the financing term is also for over the useful life term of the asset, so the business has to return the $1500 I gave it over 3 years. I am excluding any interests, since it is my own business, I did not charge any, but in case the business borrows money from a bank, it will pay bank principle + interest over next 3 years.
Just to recap, in year 0, there is a cash outflow of $1500, on year 1 – 3, there will be cash inflow of $500 as depreciation. And the business will pay back the loan it took over 3 years. After the end of year 3, the book value of the laptop becomes 0. Now if the business can sale the laptop, the cash inflow from the sale will be added back to income. But, it the business decides to sell the laptop after the 2nd year when it’s book value is $500 ( after depreciating $1000) and its sales for $700, it will be added to income too. But it will have to pay back the lender first and then anything that is leftover can be considered as profit.
Implications of a leasing arrangement have on depreciation expense.
Under certain circumstances a business can show a leased item as an asset on balance sheet that means the business can depreciate the asset (leased item here) and also the interest expense would be recognized on cash flow statement(Investopedia, n.d.).
Here are the situations when a business can recognize a leased item as an asset on balance sheet –
o The business gains ownership of the leased item after the end of the lease term
o If the business can buy out the leased item after the lease term is over
o If the lease term is at least 75% or longer than the useful lifespan of the leased item
o The lease payment is 90% or higher than the fair market value of the leased item.
In this case, the lease obligation is recognized as the cash outflow and over the lifespan of the leased item, the business can recognize depreciation and book value of the leased item or the asset would decline. And the other calculations remain same as what we did for the depreciation of a long-term asset.
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