98 PART 1 Introduction to Managerial Finance
- Land values are notdepreciable. Therefore, to determine the depreciable value of real estate, the value of the land
is subtracted from the cost of real estate. In other words, only buildings and other improvements are depreciable.
depreciation
The systematic charging of a
portion of the costs of fixed
assets against annual revenues
over time.
modified accelerated cost
recovery system (MACRS)
System used to determine the
depreciation of assets for tax
purposes.
depreciable life
Time period over which an asset
is depreciated.
LG1 LG2 3.1 Analyzing the Firm’s Cash Flow
Cash flow, the lifeblood of the firm, is the primary focus of the financial manager
both in managing day-to-day finances and in planning and making strategic deci-
sions aimed at creation of shareholder value. An important factor affecting a
firm’s cash flow is depreciation (and any other noncash charges). From an
accounting perspective, a firm’s cash flows can be summarized in the statement of
cash flows, which was described in Chapter 2. From a strict financial perspective,
firms often focus on both operating cash flow,which is used in managerial deci-
sion making, and free cash flow,which is closely watched by participants in the
capital market. We begin our analysis of cash flow by considering the key aspects
of depreciation, which is closely related to the firm’s cash flow.Depreciation
Business firms are permitted for tax and financial reporting purposes to charge a
portion of the costs of fixed assets systematically against annual revenues. This
allocation of historical cost over time is calleddepreciation.For tax purposes, the
depreciation of business assets is regulated by the Internal Revenue Code. Because
the objectives of financial reporting are sometimes different from those of tax leg-
islation, firms often use different depreciation methods for financial reporting
than those required for tax purposes. Tax laws are used to accomplish economic
goals such as providing incentives for business investment in certain types of
assets, whereas the objectives of financial reporting are of course quite different.
Keeping two different sets of records for these two different purposes is legal.
Depreciation for tax purposes is determined by using themodified accelerated
cost recovery system (MACRS); a variety of depreciation methods are available for
financial reporting purposes. Before we discuss the methods of depreciating an
asset, you must understand the depreciable value of an asset and the depreciable
life of an asset.Depreciable Value of an Asset
Under the basic MACRS procedures, the depreciable value of an asset (the amount
to be depreciated) is itsfullcost, including outlays for installation.^1 No adjustment
is required for expected salvage value.EXAMPLE Baker Corporation acquired a new machine at a cost of $38,000, with installation
costs of $2,000. Regardless of its expected salvage value, the depreciable value of
the machine is $40,000: $38,000 cost$2,000 installation cost.Depreciable Life of an Asset
The time period over which an asset is depreciated—itsdepreciable life—can sig-
nificantly affect the pattern of cash flows. The shorter the depreciable life, the
more quickly the cash flow created by the depreciation write-off will be received.
Given the financial manager’s preference for faster receipt of cash flows, a shorter