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?
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In capital budgeting, cash flows are important and not net income, since the cash flows are discounted. The depreciation method should be such which has higher cash flows initially. The reason is that since cash flows are discounted, higher cash flows initially would have a higher present value as compared to higher cash flows later in the life of the project. Accelarated cost recovery ...
The solution explains which depreciation method is better when doing a capital budgeting analysis.