10: Cash Flow and Capital Budgeting10 -1c FIXED ASSET
Many capital budgeting decisions involve the acquisition of a fixed asset. The cost of this investment often
appears as the initial cash outflow for a project. Additional factors that influence the cash consequences
of asset acquisitions include installation costs and after-tax proceeds from sales of any existing assets that
are being replaced.
In many cases, the cost of installing new equipment can be a significant part of a project’s initial
outlay. For tax purposes, companies combine the asset’s purchase price and its installation cost to
arrive at the asset’s depreciable basis, which is often recognised as an immediate cash outflow. In future
years, though depreciation itself is not a cash outflow, we have seen that depreciation deductions affect
future cash flows by reducing taxes. (This is also referred to as the depreciation tax shield). Depreciation
deductions influence taxes through another channel when companies sell old fixed assets. Specifically,
when a company sells an old piece of equipment, there is a tax consequence if the selling price differs
from the old equipment’s book value. If the company sells an asset for more than its book value, the
company must pay taxes on the gain. If a company sells an asset for less than its book value, then it can
treat the loss as a tax-deductible expense.LO10.2
depreciation tax shield
This is the tax deduction that
comes from the depreciation of
an asset. When this tax shield
is applied, the book value of
the asset is reduced by this
amountDEPRECIATION RULES AND PETROL PRICES
In the spring of 2007, petrol prices in the US climbed
to record levels. Consumers complained about what
it cost them to fill up, and politicians threatened to
remove special tax breaks that benefited ‘Big Oil’.
One widely cited explanation for the jump in
petrol prices was limited refining capacity in the
US. To what extent do US tax laws create incentives
for new refining capacity? A 2007 study by Ernst &
Young compared investment incentives in the oil-
refining companies embedded in the tax codes of
the US and 11 other countries. Essentially, Ernst &
Young looked at the depreciation allowances granted
to investments in refining plant and equipment and
calculated what fraction of an initial investment in
refining capacity could be recovered during the
investment’s first five years. The accompanying table
reports their findings. In the US, less than two-thirds
of the up-front cost could be recovered in five years,
compared with almost 80% in Canada and Taiwan,
and roughly 90% in Korea and Malaysia. In only three
countries were the recovery rates slower than they
were in the US. Aggravating the problem, the US
has one of the highest corporate tax rates among
these nations. The report concluded that, with itscombination of high tax rates and relatively long
write-off periods for new investments, the US lags
much of the world in the incentives it provides for
new investments in energy.Source: International Comparison of Depreciation Rules and Tax Rates for
Selected Energy Investments, Prepared for American Council on Capital
Formation, Ernst & Young, May 2007.Country Percentage of capital costs
recovered after five years of
petroleum refining
Malaysia 90.0%
Korea 89.0%
Canada 79.6%
Taiwan 78.5%
Germany 72.3%
Japan 72.3%
India 66.1%
Brazil 63.1%
US 63.1%
Indonesia 45.0%
China 39.8%
Mexico 32.3%
Source: © Commonwealth of Australia 2014finance in practice