Question

Which of the following correctly describes the relationship between depreciation, income, taxes, and investment cash flows?

a) As depreciation expense increases, net income and taxes will decrease, while cash flows will increase.
b) As depreciation expense increases, income, taxes, and cash flows will all decrease.
c) As depreciation expense increases, income, taxes, and cash flows will all increase.
d) Depreciation expense has no effect on income, taxes, or cash flows.

Answer 1

As depreciation expense increases, income, taxes, and cash flows will all decrease.

Step-by-step explanation:

Depreciation is a non-cash expense that reduces the value of an asset over time. As depreciation expense increases, it is subtracted from the revenue to calculate net income. Since net income is used as a basis for calculating taxes, an increase in depreciation leads to a decrease in both income and taxes. Additionally, depreciation is added back to net income when calculating cash flows, so an increase in depreciation results in a decrease in cash flows as well.

In more detail, consider the following formula for calculating cash flows:

`\[Cash\ Flows = Net\ Income + Depreciation\]`When depreciation increases, the net income decreases, and the positive impact of depreciation on cash flows is offset. Moreover, higher depreciation reduces the taxable income, leading to a decrease in taxes paid. Therefore, option b accurately reflects the relationship between depreciation, income, taxes, and cash flows.

It's crucial for financial analysis to understand the implications of depreciation on various financial metrics, as it directly influences a company's reported profitability and tax liabilities. As businesses make investment decisions, recognizing the impact of depreciation on cash flows is essential for accurate financial planning and decision-making.