Capital Budgeting and Depreciation Methods
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What are the important differences in the way operating risk (versus financial risk) enters into the consideration of a capital budgeting project?"
Phyllis believes that the firm should use straight-line depreciation for a capital project, because it results in higher net income during the early years of the project's life. Joanna believes that the firm should use the modified accelerated cost recovery system depreciation because it reduces the tax liability during the early years of the project's life. Assuming you have a choice between depreciation methods, whose advice should you follow? Why?
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Solution Summary
This solution explains the important differences in the way operating risk vs. financial risk enters into the consideration of a capital budgeting project. This solution also explains the best method for depreciation between straight-line and the modified accelerated cost recovery system depreciation method (MACRS).
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We're talking about two separate areas, so the reasons will be different. When we deal with operating risk, we're dealing with the cash requirements that are immediate - the amount of working capital needed to continue operations without sacrificing quality or compromising any processes that have been in place. We can compare this to our household. It's the amount needed to pay the mortgage and the utilities, plus buy food and have enough for regular, routine operating conditions. We have to consider operating risk in a capital budgeting project. This ...
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