Introduction to Corporate Finance

10: Cash Flow and Capital Budgeting

Sales $30,000

Less: Cost of goods 10,000

Pre-tax income $20,000

Less: Taxes (30%) 6,000

After-tax income $14,000

Plus: Depreciation tax savings 3,000 (30% × $10,000)

Total cash flow $17,000

example

10 -1b DEPrECIATION

The largest non-cash item for most investment projects is depreciation. Analysts must know the magnitude

and timing of depreciation deductions for a given project, because these deductions affect the taxes that the

company will pay. Treating depreciation properly is complicated, because the law allows companies to use

several different depreciation methods. For example, in Australia, the United States and the United Kingdom,

companies keep separate sets of books, one for tax purposes and one for financial reporting purposes, using

different depreciation methods. Their goal is to show low taxable income to the taxing authorities and stable,

growing income to investors. As a result, most US and UK companies use accelerated depreciation methods

for tax purposes and straight-line depreciation for financial reporting. In contrast, in nations such as Japan,

Sweden and Germany, the law requires that the income companies report to the tax authorities be substantially

the same as the income they report to investors. Because we are interested in the cash flow consequences of

investments, and because depreciation only affects cash flow through taxes, we consider only the depreciation

method that a company uses for tax purposes when determining project cash flows.

Depreciation is supposed to reflect the effective useful life of an asset. Thus, unless there are specific

tax incentives allowing companies to do so, companies cannot claim the full cost of acquiring an asset in

the year of acquisition. They effectively incur this cost (in the form of depreciation) in annual increments,

which are supposed to match the timing of the taxable income derived from the assets. The useful life of

an asset is either predetermined by the company when it is purchased, or the company can use the rates

determined by the Australian Tax Commissioner. Table 10.1 provides some examples of these.

TABLE 10.1 EXAMPLES OF EFFECTIVE LIVES OF ASSETS FROM JULY 2013

The following table provides examples of effective lives that were determined to be applicable from 1 July 2013 by the

Australian Tax Commissioner.

LO10.2

When calculating the net

present value of a project, we

can depreciate the cost of the

investment on either a straight-

line basis or a reducing balance

basis. Which depreciation

method should we use?

thinking cap

question

Depreciating asset Effective life in years

Carpets:

in commercial office buildings 8

in 10-pin bowling centres 4

Computers:

generally 4

laptops 3

(continued)