Help with depreciation under capital budgeting.

CFA Level II Corporate Finance
#1

HI All,

Noticed something confusing in the readings, wanted to see if you can shed some insight. With regards to capital budgeting we all know that the tax affects of depreciation needed to be added back to operating income. The thing is, the CFA questions use different terms of cash flow, and in some instances this really affects the answer.

For example, based on my understanding, if the text says an equipment will increase revenues and cash operating expenses, the term cash operating expenses means to exclude depreciation. So you still need to do (s-c-d) x (1-t) + d. However if it says operating income after tax of 40, this is after taking depreciation expense, in which case you just need to add back D to get after tax operating cash flow. However it gets confusing bec ive also seen the term “operating costs” which is shown to exclude depreciation. So you still need to subtract depreciation.

How will we know whether the exam definition of “costs/operating expenses” includes depreciation when it doesn’t explicitly say cash expenses?

#2

It is true that depreciation is a non cash item. One cannot blindly assume that whenever operating cost info is given, it has be treated as only non-cash or not. Supplementary info should be relied upon. i.e. if tax rates are available and depreciation info is given, one may have to verify the value of op profit after tax with the numbers given. If dep info is not given, we have to understand that operating costs do not include dep. The way you are treating dep is absolutely correct. Generally only ‘cash expenses’ figure would be rarely provided. Hope this clarifies.