Why do we need to consider depreciation in the financial analysis of energy projects? Explain using a simple but appropriate example.
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Expert Chegg Question Answer:
The depreciation refers to a charge which leads to a decrease in the book value of an asset due to the wear damage or the amount of time it has used has a direct impact on the value of the Asset. We need to consider the depreciation while doing the financial analysis to decrease the cost of the asset by getting the benefit of the reduction in the value of the asset. The depreciation helps to reduce the revenue which the projects are able to generate and helps to reduce the tax liability of the project and helps in getting more income for the company. As we all know that we get the reduction for the depreciation while calculating the taxable income so when the taxable income is reduced by taking the deduction of the depreciation our tax liability decreases as a result we are able to get the higher after-tax profit. There are various methods by which we can charge the depreciation like straight line method double declining method, sum of digit method etc. The depreciation also helps to decide the useful life up to which the project should be used it helps in to decide when the company should refinance or Re purchased the new equipment.
For example, the value of the machinery in year one is 18000 and the depreciation for year 1 is 5000 whereas the revenue generated by the company including all the inflows is 10,000 and the tax rate is 20%.
So, Tax without including depreciation = 10,000 * 20% = 2000
After Tax Profit = 10,000 – 2000 = 8000
Now if we take deduction of the depriciation
Tax = ( 10,000 – Depricitation ) * 20% = ( 10,000 – 5000 ) * 20% = 1000
So, After Tax profit = 10,000 – 1000 = 9000
Show me the depreciation we are able to get higher after tax profit which is very beneficial for the company.
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