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3.8. Depreciation – an overview relevant to cash flows

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Principles of Corporate Finance – A Tale of Value

Moscow Institute of Physics and Technology

5 (6 ratings) | 1.5K Students Enrolled

Course 2 of 5 in the Understanding Modern Finance Specialization

The study of Corporate Finance seems to be a very generic part of business education. Still, it either falls in the trap of intimidating formulas or is superficially journalistic. Both extremes preclude the understanding of the core finance ideas, concepts, and models. This Course is an attempt to avoid the above extremes. We discuss the core basis and mechanisms of modern corporate finance in a learner-friendly way. We will analyze the market’s most fundamental problems, realize the intrinsic interests and preferences of investors, reveal the true meaning of specific financial terms, and uncover important issues that are so often ignored in choosing and valuing investment projects. The learners will gain insight into the essence of corporate finance. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses.

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5 (6 ratings)

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From the lesson

Making the Choice of Good Investment Projects. NPV and Other Criteria. Why Is NPV Better?

We start Week 3 of the Course by the discussion of criteria of choosing investment projects. Beside NPV, the internal rate of return (IRR) and other approaches are introduced. We show why the NPV criterion is the best and why the application of others may lead to wrong investment decisions. Then we focus on the main ideas to be taken into account while setting up cash flow patterns and making the choice of project on the basis of NPV. We mention some special issues – relevant costs, depreciation, inflation. We present the concept of equivalent annual cost (EAC) as a method of comparing projects of different length. Then we study the application of EAC in greater detail in a case.

3.1. Why use NPV as a criterion of the choice of projects?5:53

3.2. Other criteria – pluses and minuses8:26

3.3. Internal rate of return (IRR)8:28

3.4. Problems with IRR – it’s not exactly like NPV!12:52

3.5. Using NPV – what should we know3:58

3.6. NPV and cash flows. Some accounting details11:39

3.7. Sunk costs – opportunity costs – relevant costs10:55

3.8. Depreciation – an overview relevant to cash flows5:51

3.9. Discount rates – nominal and real. The role of inflation6:02

3.10. Projects of different length. Equivalent annual cost (EAC)9:32

3.11. EAC – an example11:58

3.12. Conclusions and unanswered questions10:15

Taught By

Konstantin Kontor
Director and Professor of Finance and Strategy

Transcript

A few words about depreciation. Again, the accounting area invented. But for us, the important thing is that it plays a very important role, and must be taken account in investment projects. Well, the idea is simple, but we know that this is sort of physical wear and then the accounting treatment. But for us, the most important idea will be that depreciation is a non-cash expense. So basically, if this is revenue. And we put loads cash, and if C, these are costs, and also cash. Then depreciation, well, I will use only D because there's also amortization of intangible assets, but that is the accounting thing. We talk about that in our third course but not for now. This is non-cash expense. However, Depreciation reduces the base from which you pay taxes, so it does save you some cash. And this is savings. This is called the depreciation tax shield and this is d x t, where d is the depreciation charge for the period of time, and t's the tax rate. Now oftentimes, people, when they go over financial statements. They see that it's a widely used procedure to add depreciation back and sometimes there may be a contradiction between this idea DT or just D. And on the next chart I will show to you what actually occurs here. And that removes this veil of contradiction. So again We deal with R,C, and D. And first of all, we know that R minus C, which is EBITDA. This is the difference between cash revenues and cask costs. Now, let's see what happens with cash. What's the resulting cash? This is R minus C. And then we also save on taxes. So we have to pay some taxes, but how much exactly? The base is (R-C-D) now times T. So this is the general formula. Now this formula can be represented in Two ways,one way is I take R-C from here and from there. This is 1-T and then the remaining part is +DT so you're talking about. Basically EBD then you take it after Texas and then this is your depreciation text shield. Or you can rewrite that in a way that this is equal to meth income plus the. It's easy to see but then if you think about these two things then once and for all you can see that this is sort of important and then there is no contradiction. So if you go over the income statement of a company, you go all the way down to net income and to get the proxy. To the cashflow you just add D, or you go this way and then you study this depreciation tax shield. This is a sort of better or wider used things in corporate finance but the [INAUDIBLE] is no contradiction. So, basically, what we have to keep in mind here is that depreciation is important. So when you are comparing projects for which depreciation plays a key role, let's say you are comparing two pieces of equipment of different useful life, of different useful cost, and of different depreciation charges, that may be the key component of Cash flow associated with that. We will have an example of that later this week. And another important thing is that depreciation as a nominal cash flow maybe is sometimes discounted this portion. Maybe discounted in nominal cash flows while the while the components of cache cost their sort of real and they're discounted at a different rate. We will talk about that in the next episode but for now, we are done with that, and we will have one more short discussion of what must be kept into account when you're dealing with discount rates. Again, for the purpose of this week, we take them as givens. But we will in just a few moments discuss what exactly must be really looked at and how that is linked with our analysis of cash flows that we've been doing here before.

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