Homework question on capital budgeting decisions
I am not clear on why cashflows are used rather than net income for capital budgeting decisions.
If project A will have $100 of depreciation and generate $100 of cash inflows per year then it would show as producing $100 in cashflows but $0 in profits. If a firm correctly estimates the usable life of an asset, then the project may generate cashflows that look good but in reality the firm is not actually making any money to show for the investment. After the useful life of the asset is over and they have to invest again to replace it, they are still at square one. I don't see how this is superior, unless this method assumes that firms will intentionally choose shorter useful life periods for depreciation purposes, while knowing that the asset will actually have a longer useful life in reality. Could someone please help me to understand this?
It would actually lose money.
Hard to comment as we don't know the specifics, but yes since this is a theory question and you fully depreciate the asset it should have no residual value and no more usable life so it would be useless.
If depreciation always counteracted cash flows you would at best break even from a cash on cash perspective and would actually lose money as you invested in an upfront payment and received no return on the project so time value of money would put you in the negative from an NPV perspective.
TL;DR from the details you have provided if don't take the project is an option, choose it.
I agree with you 100%, but my textbook says that making an investment with $100 in depreciation and $100 in expected cashflows is a good idea. Is there any possible reason why this could be the case from a financial perspective? I mean there is the possible strategic argument that the company may need to stay relevant in its industry and therefore needs to upgrade equipment or something like that, or the alternatively if the firm is intentionally claiming a shorter useful life for depreciation purposes in order to maximize its tax break. Neither of these sounds like a reasonable answer for an intro corporate finance class though, it just sounds like a crock of shit.
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