1 analyzing the firms cash flow cash flow the

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Unformatted text preview: s. I 97 98 PART 1 LG1 Introduction to Managerial Finance LG2 3.1 Analyzing the Firm’s Cash Flow Cash flow, the lifeblood of the firm, is the primary focus of the financial manager both in managing day-to-day finances and in planning and making strategic decisions aimed at creation of shareholder value. An important factor affecting a firm’s cash flow is depreciation (and any other noncash charges). From an accounting perspective, a firm’s cash flows can be summarized in the statement of cash flows, which was described in Chapter 2. From a strict financial perspective, firms often focus on both operating cash flow, which is used in managerial decision making, and free cash flow, which is closely watched by participants in the capital market. We begin our analysis of cash flow by considering the key aspects of depreciation, which is closely related to the firm’s cash flow. Depreciation depreciation The systematic charging of a portion of the costs of fixed assets against annual revenues over time. modified accelerated cost recovery system (MACRS) System used to determine the depreciation of assets for tax purposes. Business firms are permitted for tax and financial reporting purposes to charge a portion of the costs of fixed assets systematically against annual revenues. This allocation of historical cost over time is called depreciation. For tax purposes, the depreciation of business assets is regulated by the Internal Revenue Code. Because the objectives of financial reporting are sometimes different from those of tax legislation, firms often use different depreciation methods for financial reporting than those required for tax purposes. Tax laws are used to accomplish economic goals such as providing incentives for business investment in certain types of assets, whereas the objectives of financial reporting are of course quite different. Keeping two different sets of records for these two different purposes is legal. Depreciation for tax purposes is determined by using the modified accelerated cost recovery system (MACRS); a variety of depreciation methods are available for financial reporting purposes. Before we discuss the methods of depreciating an asset, you must understand the depreciable value of an asset and the depreciable life of an asset. Depreciable Value of an Asset Under the basic MACRS procedures, the depreciable value of an asset (the amount to be depreciated) is its full cost, including outlays for installation.1 No adjustment is required for expected salvage value. EXAMPLE Baker Corporation acquired a new machine at a cost of $38,000, with installation costs of $2,000. Regardless of its expected salvage value, the depreciable value of the machine is $40,000: $38,000 cost $2,000 installation cost. Depreciable Life of an Asset depreciable life Time period over which an asset is depreciated. The time period over which an asset is depreciated—its depreciable life—can significantly affect the pattern of cash flows. The shorter the depreciable life, the more quickly the cash flow created by the depreciation write-off will be received. Given the financial manager’s preference for faster receipt of cash flows, a shorter 1. Land values are not depreciable. Therefore, to determine the depreciable value of real estate, the value of the land is subtracted from the cost of real estate. In other words, only buildings and other improvements are depreciable. CHAPTER 3 TABLE 3.1 Property class (recovery period) Cash Flow and Financial Planning First Four Property Classes Under MACRS Definition 3 years Research equipment and certain special tools. 5 years Computers, typewriters, copiers, duplicating equipment, cars, lightduty trucks, qualified technological equipment, and similar assets. 7 years Office furniture, fixtures, most manufacturing equipment, railroad track, and single-purpose agricultural and horticultural structures. 10 years recovery period The appropriate depreciable life of a particular asset as determined by MACRS. 99 Equipment used in petroleum refining or in the manufacture of tobacco products and certain food products. depreciable life is preferred to a longer one. However, the firm must abide by certain Internal Revenue Service (IRS) requirements for determining depreciable life. These MACRS standards, which apply to both new and used assets, require the taxpayer to use as an asset’s depreciable life the appropriate MACRS recovery period.2 There are six MACRS recovery periods—3, 5, 7, 10, 15, and 20 years— excluding real estate. It is customary to refer to the property classes, in accordance with their recovery periods, as 3-, 5-, 7-, 10-, 15-, and 20-year property. The first four property classes—those routinely used by business—are defined in Table 3.1. Depreciation Methods For financial reporting purposes, a variety of depreciation methods (straight-line, double-declining balance, and sum-of-the-years’-digits3) can be used. For tax purposes, using MACRS recovery periods, assets in the first four property classes are depreciated by the double-declining balance (200 percent) method, us...
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