Impacts of Depreciation Method Choice on Capital Budget Analysis

When analyzing capital projects, companies are incentivized to apply accelerated depreciation methods (refer to Financial Reporting part 1 for more on these methods) because accelerating depreciation generates higher after tax cash flows in the project’s early years.
As a result of higher early year after-tax cash flows, accelerated depreciation methods typically create higher net present values when compared to the straight line depreciation method.
Some countries allow the use of special depreciation methodologies solely for tax reporting purposes, but not for financial reporting purposes.
The U.S. tax code allows companies to use the Modified Accelerated Cost Recovery System (MACRS), which has a specific depreciation schedule for different categories of capital investment.
An objective of MACRS is to incentivize companies to make investments by reducing their tax burden.