Corporate Finance

NS e-Prep Course

Nanyang Technological University
Concepts

Concepts in Finance – Answer
Q. How do depreciation and other noncash charges act as sources of cash inflow to the firm? Why does a depreciation allowance exist in the tax laws? For a profitable firm, is it better to depreciate an asset quickly or slowly for tax purposes? Explain.

ADepreciation and other non-cash charges are sources of cash to the firm. These charges are subtracted from the firm’s revenues, decreasing cash flow in order to get a correct estimate of taxes owed. They need to be added back to compute an accurate cash flow. These charges are not real cash flows – no dollars exchange hands when a company takes a depreciation expense – and are only subtracted because they reduce the company’s tax bill, and taxes are a real dollar cash flow. The tax code does not allow a company to expense its capital equipment in the year it was purchased. It requires company’s to charge this expense over the lifetime of the equipment, taking a percentage of the total cost each year. For a profitable firm, it is better to depreciate assets as quickly as possible. The larger the depreciation expense, the lower the taxable income and the lower the taxes owed.

Go to Concepts in Finance page
Go to Engineering Economy and Corporate Finance ePrep page
Go to Business Finance ePrep page
Go to ePrep Home page