NPV and depreciation

CFA Level II
#1

Hello all,

Can someone clarify - does moving from straight line depreciation to another form of accelerated depreciation increase the NPV of a project?

if so, is this because the tax shield is bigger in the beginning?

thanks.

#2

yes - that’s exactly right. there are no cash flows associated with depreciation, but the higher the depreciation expense, the higher the tax shield. by recognizing more expense in the early years, you’ll get a higher NPV

#3

Thank you!

#4

With straight line depreciation, accelerated depreciation or units of production, the tax expense, depreciation amount and net income are the same over the entire period. But can someone please clarify why higher depreciation (under say accelerated depreciation) leads to a higher NPV? Higher depreciation means lower net income, so not sure how this translates to higher NPV?

#5

First off, NPV is the NPV of Cash Flows, not Net Income. But that’s not a major point because if total depreciation is the same over the project life, total Net Income will be too. The question is why the NPV of cash flows is greater under accelerated depreciation.

With accelerated depreciation, the depreciation occurs sooner. Depreciation results in a tax shield (equal to Depreciation x tax rate). To see this, note that CF = (revenue-Costs)(1-tax rate) + (Depreciation)(tax rate) – the first term is the cash flow without depreciatio and the second is the cash flow from depreciation (i.e. the tax shield from depreciation).

Accelerated depreciation means that the cash flows from depreciation occur sooner than with straight-line. And the PV of a near-term cash flow is greater than the PV of a more distant cash flow.

#6

Nice explanation, thanks

#7

Glad it helped.