Summary of chapter 4 of Principles of managerial finance. Written by Lawrence J. Gitman, 14th edition. Written for IBMS students of Avans or for the course Investment decisions.
Depreciation – a portion of the costs of fixed assets charged against annual revenues over time.
Depreciation deductions are not associated with any cash outlays!
The net effect is that depreciation deductions increase a firm’s cash flow, because they reduce a
firm’s tax bill.
Depreciation for tax purposes is determined by using the modified accelerated cost recovery
system (MACRS).
Depreciable value of an asset
The depreciable value of an asset is its full cost, including outlays for installation.
Depreciable life of an asset
Depreciable life – time period over which an asset is depreciated.
The shorter this life, the larger the annual depreciation deductions, and the larger will be tax
savings be.
Recovery period – Appropriate depreciable life of a particular asset as determined by MACRS.
Depreciation methods
For financial reporting purposes, companies use of variety of depreciation methods:
straight-line, double-declining balance, and sum-of-the-years’-digits.
For tax purposes, assets in the first 4 MACRS property classes are depreciated by the double-
declining balance method, using a half-year convention
(= a half-year’s depreciation is taken in the year the asset is purchased). They switch to straight-
line depreciation when advantageous.
The depreciation percentages for an n-year class asset are given for n + 1 years.
So a 5 year assets is depreciated over 6 recovery years.
Developing the statement of cash flows
Statement of cash flows – summarizes the firm’s cash flow over a given period.
Analysist lump cash and marketable securities together when assessing the firm’s liquidity, because
both represent a reservoir of liquidity. That reservoir is increased by cash inflows and decreased by
cash outflows.
The firm’s cash flows fall into 3 categories:
- Cash flow from operating activities
- Cash flow from investment activities
- Cash flow from financing activities
Cash flow from operating activities – cash flows directly related to sale and production of the
firm’s products and services.
Cash flow from investment activities – cash flows associated with purchase and sale of both
fixed assets and equity investments in other firms.
Cash flow from financing activities – cash flows that result from debt and equity financing
transactions; include incurrence and repayment of debt, cash inflow from the sale of stock, and
cash outflows to repurchase stock or pay cash dividends.
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