How can you account for depreciation in capital budgeting analysis?
Capital budgeting is the process of evaluating and selecting long-term investments that align with the strategic goals of an organization. One of the key factors that affect the profitability and feasibility of a project is depreciation, which is the reduction in the value of an asset over time due to wear and tear, obsolescence, or other factors. In this article, you will learn how to account for depreciation in capital budgeting analysis and why it is important for financial decision making.
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1 What is depreciation?
Depreciation is an accounting method that allocates the cost of an asset over its useful life, reflecting how much of its value is consumed or lost each period. Depreciation is a non-cash expense, meaning that it does not affect the cash flow of the business, but it reduces the net income and the taxable income. There are different methods of calculating depreciation, such as straight-line, declining balance, or units of production, depending on the nature and usage of the asset.
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2 How does depreciation affect capital budgeting?
Depreciation affects capital budgeting in two main ways: it impacts the initial investment and the operating cash flows of the project. The initial investment is the amount of money required to acquire and install the asset, and it is usually the largest cash outflow in capital budgeting. Depreciation reduces the initial investment by allowing the business to recover some of the cost of the asset through tax deductions. The operating cash flows are the net cash inflows or outflows generated by the project during its life, and they are used to measure the profitability and viability of the project. Depreciation increases the operating cash flows by reducing the taxable income and the tax payments of the business.
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3 How to account for depreciation in capital budgeting analysis?
In order to account for depreciation in capital budgeting analysis, you need to estimate the cost and useful life of the asset, and choose an appropriate depreciation method. Subsequently, calculate the annual depreciation expense for each year of the project, deduct it from the earnings before interest and taxes (EBIT) to get the earnings before taxes (EBT), apply the tax rate to the EBT to get the tax payments, and add back the depreciation expense to get the net operating profit after taxes (NOPAT). Additionally, subtract the change in net working capital and the capital expenditures from the NOPAT to get the free cash flow (FCF) for each year of the project. Finally, discount the FCFs by the weighted average cost of capital (WACC) to get the present value (PV) of the cash flows, sum them up to get the net present value (NPV) of the project, and compare it with the initial investment to determine if it is worth pursuing or not.
How to Calculate Capital Expenditure Depreciation Expense
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Over time, the value of a company’s capital assets declines. This is a normal phenomenon driven by wear and tear, obsolescence, and other factors. This depreciation in the asset’s value must be accounted for on the company’s income statement and balance sheet to capture the loss in value over time as an expense and as a reduction in the asset’s actual value.
To calculate this capital expenditure depreciation expense, the company’s accounting team must use the asset’s purchase price, its useful life, and its residual value. Here’s how.
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What depreciation method to use
First, what depreciation method should be used?
There are numerous methods an accountant can use to calculate an asset’s depreciation expense. The method chosen will depend on the asset, the implications for the income statement, and a company’s internal policies.
In the example below, we’ll keep it simple and use the straight-line depreciation method. This method accounts for depreciation by taking the same amount as an expense each year over the asset’s useful life. This method is common for depreciating assets that gradually and consistently succumb to wear and tear over time. The wear and tear on the building’s roof, for example, is likely to wear down equally in its second year as it is in its sixth or seventh year.
While simple enough, the straight-line method is not always the best choice. Accelerated depreciation allows a company to take a larger depreciation expense in the first few years after the asset is purchased and smaller amounts in later years. This method makes sense logically in the context of, for example, an automobile. The moment the car is driven off the sales lot, it loses a large percentage of its value. As it ages though, the rate at which it loses value decreases. In this case, the real-world reality of purchasing a vehicle is best represented with an accelerated depreciation schedule. Taking more depreciation up front also has the advantage of reducing the company’s tax liability, which can be a major factor in management’s approach to its depreciation policy.
The two most common accelerated depreciation methods are the double-declining method and the sum-of-year method. For even more complex situations, a company could elect to use even more involved accounting methods like the hours-of-service depreciation method or the unit-of-production method.
Calculating straight-line depreciation
Calculating straight-line depreciation
For this example, let’s assume that a farmer purchases a tractor for $25,000 that he expects will last him 10 years. At the end of this 10-year period, the farmer reckons he can sell the tractor on the used market for $8,000.
Using the straight-line method, we know that we will be creating a constant depreciation expense every year. We also know that the book value of the tractor should equal $8,000 after 10 years (this is its residual, or salvage, value).
To calculate how much should be expensed as depreciation each year, we first subtract the $8,000 residual value from the original $25,000 purchase price. That result, $17,000, is then divided by the number of years in the tractor’s useful life, in this case 10 years, to give us our annual depreciation expense for the tractor. $17,000 divided by 10 years is $1,700 per year.
| Time | Depreciation Expense | Accumulated Depreciation | Book Value |
|---|---|---|---|
| Purchase | $1,700 | $0 | $25,000 |
| Year 1 | $1,700 | $1,700 | $23,300 |
| Year 2 | $1,700 | $3,400 | $21,600 |
| Year 3 | $1,700 | $5,100 | $19,900 |
| Year 4 | $1,700 | $6,800 | $18,200 |
| Year 5 | $1,700 | $8,500 | $16,500 |
| Year 6 | $1,700 | $10,200 | $14,800 |
| Year 7 | $1,700 | $11,900 | $13,100 |
| Year 8 | $1,700 | $13,600 | $11,400 |
| Year 9 | $1,700 | $15,300 | $9,700 |
| Year 10 | $1,700 | $17,000 | $8,000 |
From an accounting perspective, each year the income statement will show the $1,700 as a depreciation expense. On the balance sheet, each year’s depreciation expense will add into the accumulated depreciation account, which is subtracted from the tractor’s purchase price to give its book value, or net asset value.
The reality of many capital assets
Depreciation, cash flow, and the reality of many capital assets
Depreciation is a noncash expense. In the tractor example above, the only time the farmer actually reduced his cash on hand was when he purchased the tractor. For the next 10 years, though, the tractor spent thousands of hours around the farm and in the fields, rain or shine. The farm needs a working tractor to operate; every day the tractor fires up and gets to work is one day closer to the time it will need to be replaced. When that time comes, that means spending cash for a new tractor.
So while the tractor’s depreciation expense is a noncash expense for all the years it is in use on the farm, the tractor was actually losing real value that will one day require a cash expense. The same is true for many other assets — machines wear down and must be replaced, buildings need new roofs from time to time, vehicles only run for so long.
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Depreciation expense is just our way of accounting for that reality over time, balancing the fact that it costs cash to purchase an asset today and to replace it in the future, but we can only expense these purchases with the asset’s use over time.
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