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Looking for some urgent assistance in understanding the way depreciation is being treated. I understand that it is not a cash flow. But because if this I am Not understanding why it needs to be added back to cashflow figures.
For instance, if a question States that depreciation has been included in the profit estimates why would you need to then add the depreciation to make the adjustment versus deduct?
I am really confused.
It would have to be added back as an adjustment. If non-cash flows have been included in figures and you are attempting to find cash flows the effects of these non-cash flows have to be removed. Since depreciation is an expense it has to be added back.
No cash movement occurs as a result of depreciation. Assume a machine is bought for $1000 and is depreciated over 10 years on a straight line basis with no residual value. $100 will be charged in profit and loss. However, only the $1000 the machine was bought for involved money moving out of the entity concerned. The $100 therefore has to be added back to derive what cash flow would have been without this “paper” expense.
I have another question relating to this topic. But firstly is there any material I can read on this depreciation adjustment?
I understand that the depreciation is not a cash flow so it needs to be added back inorder for the true cash movement to be realised.
However, while practicing I have realised that this is not the case when scrap or residual value is present.
Is this only when the questions speaks specifically about the inflows being profits?
The scrap or residual would be relevant as it would be an expected future case flow.
This scenario relates to two requirements.
Mem Co manufactures a specialist component and is considering buying a replacement machine costing $2.5m. This machine would operate for five years after which time it would be sold for $100,000.
The replacement machine would have a production capacity of 300,000 components per year which is 50,000 more components per year than the existing machine produces. Mem Co is able to sell all components produced.
Other information
•If Mem Co purchased the replacement machine it would require a concrete foundation which would cost $15,000. The site has already been assessed as suitable for the foundation by a surveyor who charged a $3,000 fee. This fee has not yet been paid.
•If the existing machine were scrapped it could be sold for $48,000 cash now. Otherwise it would last for a further five years at which time its scrap value would be zero.
•The selling price of $14 per component would not change if the replacement machine were purchased.
•Variable costs are currently $6.60 per component and the replacement machine’s variable costs would be $5.00 per component
Cash fixed costs would increase by $43,000 per year if the existing machine were replaced.
Mem Co uses a 9% cost of capital to evaluate projects of this type.
(a) Calculate the net present value (NPV) of the replacement machine and conclude whether Mem Co should buy the replacement machine. Show all calculations.
for instance why isnt depreciation taken into account in this question? i understand residual values are inflows but why isnt depreciation adjusted for here?
The depreciation would be irrelevant. As would the surveyor’s fee as it is a past cost.
Relevant costs are defined by being in future, cash flows and are avoidable.
Replacement machine bought calculation- positive flows. Sale of existing machine $48000.
Increased contribution each year from reduction of variable costs on each unit.
Increased contribution on extra capacity of 50000 units per year.
Residual value from sale of new machine at end of 5 years.
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