Evaluate the statement - “Depreciation generated funds have no explicit cost and therefore should be assigned a zero cost in computing a firm’s cost of capital schedule.”
Depreciation generated funds have no explicit cost and therefore should be assigned a zero cost in computing a firm's cost of capital schedule
Consider that a business owns a 3D printer which forms the core of the business. They use the printer on a daily basis to fulfill customer orders. The purchasing price of the printer is $25,000 with a life expectancy of 10-years. In its lifespan, the printer can print upto 250,000 3D items. Rather than taking the whole $25,000 expense at once, accounting rules allow the business to spread the cost of the assets over its useful life (which is 10-years here). This concept is called depreciation. It allows business to take out a certain percentage of the invested amount on the asset each year while it’s making money for the business (Dammon & Senbet, 1988).
Explicit cost, on the other hand, takes out money from the company while affecting the cash flow of the business (Walia, 1977). Let’s look at an example to understand this well, you own a pizza house at Thamel. As part of the business, you’ve employed three full-time employees and an equal number of part-time employees as well. You made an investment in the space, equipment, and furniture to ensure that you’ve got the best place in town. Every month end, you are obliged to pay the bills including the rent, salary to the staff, loans and other utility costs. These expenses are measurable and required a fixed amount of payment at the end of a period (month). This type of cost is called an explicit cost.
The expenses of depreciation are recorded in the cash flow statement as a positive amount. The company would have already placed the full expense of the product as part of liabilities while adding the product as part of assets. The depreciation that is taken into account every period is to account for the depreciation expense in the income statement taken at the initial stage of the purchase of it and to adjust the net income. Deprecation can never be a source of fund. Assigning it a zero cost helps in improving the efficiency of the process, reduce future expense, and operations while ensuring no expenses are added as part of it. No additional interest need to be paid while an assets deprecation happens. All of which is the reason why funds generated from deprecation has no explicit cost and should be assigned zero cost while computing a firm’s capital schedule.
Dammon, R., & Senbet, L. (1988). The Effect of Taxes and Depreciation on Corporate Investment and Financial Leverage. The Journal Of Finance , 43 (2), 357-363.
Walia, T. (1977). Explicit and Implicit Cost of Changes in the Level of Accounts Receivable and the Credit Policy Decision of the Firm. Financial Management , 6 (4), 75-78.
There are two categories of cost. One is the explicit cost and the other is implicit cost. The explicit cost are the cost that can be seen such as wage, supplies, operation costs etc. These cost are used by accountants. Implicit cost are those cost that could have been received if something else was done. For example if you are self-employed then your opportunity to gain income if you worked for another company has been missed. These are form of implicit cost and economics says that it is important to note both type of costs when calculating profit. All types of cost are opportunity costs. (Foldvary, 2012)
When it comes to depreciation, the concept behind it is that not all the value of the purchased asset decrease in one year so they compute the annual cost and make reservations and charge it to the net income on annual basis. In the zero year, the value of the purchase will not be calculated as expenditure but will be recorded into asset side of the balance sheet. So every year the provision that is made in the name of depreciation is in fact the cost charged. "Depreciation is the systematic allocation of the cost of an asset with an economic life in excess of one year. (Moyer, McGuigan, Rao, & Kretlow, 2012)”
"In accounting, profit equals revenues minus explicit costs. In economics, that amount is called an "accounting profit.” But the implicit costs are also real costs, so for economics the accounting profit does not provide the real profit. (Foldvary, 2012)”
Thus according to economics any cost for purchase or exchange should be calculated as real cost while computing the actual profit. In profit and loss statement depreciation is deducted from the Net Income meaning it is considered as explicit cost and so should not be disregarded when computing the cost of capital.
Foldvary, F. E. (2012, October 22). What Is Profit? Retrieved from Foundation for Economic Education: https://fee.org/articles/what-is-profit/
Moyer, C. R., McGuigan, J. R., Rao, R., & Kretlow, W. J. (2012). Contemporary Financial Management. Natorp Boulevard: South-Western, Cengage Learning.
Depreciation applies fixed assert in your balance sheet. This group of assert is also called property, plant, and equipment. They are items that you buy to use in your business to help generate income for more than 12 months. Example, of the fixed asset, include land and building, plant and equipment furniture, fixture and fitting computer motor vehicles and truck soon. The word "fixed” doesn’t mean they are not physically able. It means they’re port of your long to term business assert. That’s why they fall in the Non - Current asset part of your balance sheet. All fixed asset has fixed asset has a finite useful life but land is the exception.
Depreciation is an accounting concept which spread the cost of a fixed asset over the term of that asset’s useful life. The length of the life depends on useful life depends on the asset. For a computer it might be 3 years, a bottling and 8 years a building maybe 20 years. The reason for spreading the fixed asset cost is match expense with income. A car or a computer or a building will be used in the business to generate income for more than one year. In another word, the cost is an expense that related to future income in your business. So it should just be expense in the month you buy it. Imagine what it your business profit. If you charged the entire cost of the factory as an exposure in one month the business. This way we don’t run the business cash balance down to zero and we also don’t have a bank debt. Let’s say the Car has a useful also don’t bank debt. Let’s the car has a useful life of 4 years. For example, if a plant purchases a generator for five years in $ 5000. And it’s per years Depreciation charge is $1000. At the mid time or in 3 years when generators have some problem and it is damaged and for our project we must need Generator. So we need to replace this with a new one and the depreciation cost $ 2000 help a small amount of capital for generator otherwise we issue the fund from main balance. So by this example, we can clearly say that depreciation definitely. Directly it doesn’t generate the cost but indirectly at the time of replacement it has a capital amount so for buying any equipment after it life cycle also help the fund for buying new equipment. So Depreciation is also a cost for financial analysis. Hence, theoretically, the most effectual method of securing this would be, if it were feasible, to Revalue everything at stated intervals, and to write off whatever loss such valuations might reveal without regard to any prescribed rate. The plan of valuing every year instead of adopting a depreciation rate, though it might appear the more perfect, is too tedious and expensive to be adopted the next best plan, which is that generally followed is to establish average rates which can without much trouble be written off every year, to check the result by complete or partial valuation at longer intervals, and to adjust the depreciation rate if required (Clark, 2004).
Clark, C. (2004). The Conditions of Economic Progress. The Macmillan Press.
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.
Haslem, J. A. (2015). Depreciation: A Source of Cash? Arizona Review, 16 , 12-14. Retrieved from https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2607213
Moyer, R. C., McGuigan, J. R., Rao, R., & Kretlow, W. J. (2012). Contemporary Financial Management (12th ed.). Oklahoma: Cengage Learning.