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Sep 2015 Q3 - why is depreciation included in NPV calculation when it is not a cashflow

Discussion in 'CT2' started by tess, Sep 10, 2018.

  1. tess

    tess Member

    I am stumped on why Sep 2015 Q3 (UK) has the correct solution for the NPV calculation as including the depreciation amount, when depreciation is not a cashflow.

    Elsewhere in the forums we have also seen that you ignore depreciation: https://www.acted.co.uk/forums/inde...m-april-2010-question-number-20-part-i.11807/

    If we change the MCQ slightly so that the machine does not increase reported profit and is effectively a useless piece of junk (just by way of argument), including depreciation will mean that NPV = -40 + 8v + 8v^2 + ... + 8v^5, or almost 0 at discount rates close to 0%. Units are in $'000

    However shouldn't the NPV for the completely useless project be NPV = -40 if it doesn't produce any cashflow?

    Thanks, hope somebody can elaborate as I'm puzzled!
     
    Last edited by a moderator: Sep 10, 2018
    tess, Sep 10, 2018
    #1
  2. Lynn Birchall

    Lynn Birchall ActEd Tutor Staff Member

    Hi

    You're correct - we don't want to deduct depreciation in an NPV calc, ie we base it on discounted cashflows, not discounted profits.

    In this Sept 2015, Q3, the question gives us the reported profits of $11k each year. So, we need to add back the $8k of depreciation each year, to get to the cashflows that we want for the NPV calc.

    Hope this helps!
    Lynn
     
    Lynn Birchall, Sep 10, 2018
    #2
  3. tess

    tess Member

    Thanks Lynn! That's a pretty subtle distinction. Will watch out for that in future!
     
    tess, Sep 11, 2018
    #3

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