Depreciation is the annual reduction in the value of assets over its useful life expressed in monetary terms. It is a non-cash expense deducted from the gross profit of an organization for the purpose of tax saving. Since the amount is not actually paid as expense, it is added in the amount of net profit to determine the cash flow for the company so it is understood as a source of fund (Moyer, McGuigan, Rao, & Kretlow, 2012). But it is important to note that depreciation does not provide cash (Haslem, 2015).
For example: A machine purchased on Rs.100,000 is depreciated to zero salvage value on straight line method over its useful life of 10 years. Then the annual depreciation of the machine will be Rs.10,000. The company show this amount as expenses in income statement but there is not physical outflow of cash depreciation expenses. This accumulated amount of Rs. 10,000 every year is kept as provisional amount and the firm can use the depreciation generated funds to finance new project.
In looking explicitly, the investors do not have any financial obligations for using the amount of depreciation used. No interest or additional cost need to be paid for the used amount. But the implicit cost or the opportunity cost of these fund is lost if it is used for financing the company’s project. For example: If the cost of capital is 12% and the company has re-invested the amount of depreciation fund, it would have earned a return of 12%. Since the company used the amount for its own purpose, the opportunity of reinvesting is foregone.
So the depreciation fund is not cost free even if it has no explicit cost. The cost of depreciation fund is equal to the weighted average cost of capital of the firm due to the opportunity cost for forgoing other investment opportunities available.
Depreciation is the annual reduction in the value of assets over its useful life expressed in monetary terms. It is a non-cash expense deducted from the gross profit of an organization for the purpose of tax saving. Since the amount is not actually paid as expense, it is added in the amount of net profit to determine the cash flow for the company so it is understood as a source of fund (Moyer, McGuigan, Rao, & Kretlow, 2012). But it is important to note that depreciation does not provide cash (Haslem, 2015).
For example: A machine purchased on Rs.100,000 is depreciated to zero salvage value on straight line method over its useful life of 10 years. Then the annual depreciation of the machine will be Rs.10,000. The company show this amount as expenses in income statement but there is not physical outflow of cash depreciation expenses. This accumulated amount of Rs. 10,000 every year is kept as provisional amount and the firm can use the depreciation generated funds to finance new project.
In looking explicitly, the investors do not have any financial obligations for using the amount of depreciation used. No interest or additional cost need to be paid for the used amount. But the implicit cost or the opportunity cost of these fund is lost if it is used for financing the company’s project. For example: If the cost of capital is 12% and the company has re-invested the amount of depreciation fund, it would have earned a return of 12%. Since the company used the amount for its own purpose, the opportunity of reinvesting is foregone.
So the depreciation fund is not cost free even if it has no explicit cost. The cost of depreciation fund is equal to the weighted average cost of capital of the firm due to the opportunity cost for forgoing other investment opportunities available.
References
Haslem, J. A. (2015). Depreciation: A Source of Cash? Arizona Review, 16 , 12-14. Retrieved from papers.ssrn.com/sol3/papers.cfm?ab...
Moyer, R. C., McGuigan, J. R., Rao, R., & Kretlow, W. J. (2012). Contemporary Financial Management (12th ed.). Oklahoma: Cengage Learning.