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.