If depreciation is not a cash flow item, why does it affect the level of cash flows from a project in any way?
Why are we interested only in incremental cash flows rather than total cash flows?
a firm utilizes a strategy of capital rationing , which is currently $250,000 and its considering the following 2 project A has a cost of $150,000 and the following cash flows:
To understand why depreciation affects the level of cash flows from a project and why we focus on incremental cash flows, let's break down each question separately.
1. Why does depreciation affect the level of cash flows from a project?
Depreciation is a non-cash expense that reflects the allocation of an asset's cost over its useful life. Although depreciation does not result in an outflow of cash, it affects the taxable income of a business. This, in turn, impacts the taxes a company has to pay.
When calculating cash flows, taxes are typically included as an expense. Since depreciation reduces taxable income, it decreases the tax liability, leading to lower tax payments. As a result, the cash flow from a project increases because the company has more cash available due to a reduced tax burden.
In summary, even though depreciation is not an actual cash outflow, it indirectly impacts cash flows from a project by reducing tax payments and increasing available funds.
2. Why are we interested only in incremental cash flows rather than total cash flows?
When evaluating the feasibility of a new project or investment, it's crucial to consider the net effect it will have on the company's overall cash flow. Incremental cash flows focus specifically on the additional cash flows generated by the project, compared to the cash flows that would have occurred without the project.
Total cash flows include all the cash inflows and outflows a company experiences, irrespective of the project. However, we focus on incremental cash flows because it helps us isolate the specific impact of the project itself.
By considering incremental cash flows, we can assess whether the project adds value to the company. It allows us to understand the project's individual contribution to the organization's overall financial position and helps in making better investment decisions.
To calculate incremental cash flows, we compare the cash flows with the project (including any additional revenues, costs, and changes in working capital) to the cash flows without the project (current or baseline cash flows). The difference represents the incremental cash flows attributable to the project.
In summary, focusing on incremental cash flows allows us to isolate and assess the impact of a project on a company's overall cash flow, helping us determine its value and make informed investment choices.