Methods of depreciation and application the discounted cashflow technique

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Answer to the Question No 01

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Answer to the Question No 02

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Reference

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Answer to the Question No 01

The process of allocating cost of tangible asset over its useful life in a logical and rational manner is called as depreciation. By depreciation, cost of an asset can be matched with revenue it generates over its useful life. It is a process of cost allocation but not a process of asset valuation. Because of being a noncash expense it lowers the company’s reported earnings while increases free cash flow.

There are two main porous of depreciation. One is accounting porpoise and another is tax porpoise. Accounting porpoise of depreciation is that it indicates how much of a tangible asset has been used up. Tax porpoise of depreciation is that it enables a company to deduct the cost of an asset they purchased as business expense.

There are many method of depreciation under Generally Accepted Accounting Principles. A company can select the method(s) which will be appropriate. In this assignment I am going to discuss about two popular depreciation methods. One is Straight Line Method and another is Reducing Balance Method.

Straight Line Method:

Straight line method is one of the most common and easiest methods that are used for depreciation. According to straight line method a tangible asset is depreciated by the same amount of the asset’s useful life. It is used when there is no particular pattern to the manner in which the asset to be used over useful life. In this method depreciation is calculated by dividing the difference between the asset’s cost (all costs which are incurred to bring the asset in usable form such as, delivery cost, installation cost etc. should be included) and estimated salvage value by the numbers of years the asset is expected to be used.

Suppose a machine has useful life of 5 years, cost of the machine is £16000. Salvage value of the machine is £1000. Here, depreciable cost for the machine will be £16000 - £1000 = £15000. So, the annual depreciation for the machine will be £15000 ÷ 5 = £3000.

Alternatively, depreciation can be calculated by annual rate of depreciation. To do so, first we have to calculate annual rate. Here, the annual rate is 100% ÷ 5 years = 20%. This annual rate of depreciation is multiplied with the depreciable cost of the asset. So the depreciation cost for this machine is £15000 × 20% = £3000.

Useful life of the machine

Depreciable cost

Depreciation rate

Annual depreciation expense

Accumulated depreciation

*Book value

Year 1

£15,000

20%

£3,000

£3,000

£13,000

Year 2

£15,000

20%

£3,000

£6,000

£1,0000

Year 3

£15,000

20%

£3,000

£9,000

£7,000

Year 4

£15,000

20%

£3,000

£12,000

£4,000

Year 5

£15,000

20%

£3,000

£15,000

£1,000

*Book value = cost – accumulated depreciation

Reducing Balance Method:

Reducing Balance Method is a method of depreciation in which a tangible asset is depreciated highly in the early part of its usable life. This depreciation amount reduces over time. In this method depreciation amount reduces because it is calculated based on the declining book value of the asset. This method of depreciation is used for those assets which have higher use in earlier years of useful life.

In this method depreciation is calculated by multiplying the book value of an asset at the beginning of the year by the depreciation rate. In the last year of useful life, depreciation is calculated by deducting the salvage value from the book value at the beginning of the period.

One of the most common forms of reducing balance method is double declining method. In this method the declining rate is computed by multiplying the straight line depreciation rate by 2. Here we will consider the same example where a machine has useful life of 5 years; cost of the machine is £16000. Salvage value of the machine is £1000.

Useful life of the machine

Book value beginning of the year

Depreciation rate

Annual depreciation expense

Accumulated depreciation

Book value

Year 1

£16,000

40%

£6,400

£6,400

£9,600

Year 2

£9600

40%

£3,840

£10,240

£5,760

Year 3

£5760

40%

£2,304

£12,544

£3,456

Year 4

£3456

40%

£1,382.4

£13,926.4

£2,073.6

Year 5

£2073.6

40%

£1,073.6*

£15,000

£1,000

*Depreciation expense is adjusted to £1,073.6 in order for book value to equal salvage value.

Difference between Straight Line Method and Reducing Balance Method:

  • In Straight Line Method, depreciation expense remains constant over the assets useful life. In the example of Straight Line Method, the machine was evenly depreciated by £3000. But in Reducing Balance Method, depreciation expense does not remain content over the assets useful life. The asset is depreciated highly in the beginning years and the depreciation expense declines over time. In the example of Reducing Balance Method, we can see that the maximum portion of the machine was depreciated in the first two years. In first two years, depreciation expenses are £6,400 and £3,840 respectively. But in the last year depreciation expense was £1,073.6.
  • In Straight Line Method, salvage value is deducted from the cost of the asset to determine depreciable cost. In the example, cost of the machine was £16,000 and the salvage value was £1,000. So, depreciable cost was £15,000 (£16,000 - £1,000). Depreciation expense of the last year did not require adjusting in order for book value to equal salvage value.

In Reducing Balance Method, salvage value is not deducted from the cost of the asset. Here depreciable cost needs not to be calculated. In the example of Reducing Balance Method, last year’s depreciation expanse £829.44 was adjusted to £1,073.6 for book value to equal salvage value.

  • In the straight line method depreciation expense is calculated based on depreciable cost. Depreciation expense is computed by dividing the depreciable cost by the number of asset’s useful years. In the example the depreciable cost was £15000 and the number of years was 5. So the depreciation expense was £3000 for each year of machine’s useful life.

In Reducing Balance Method does not consider depreciable cost. In this method depreciation expense is calculated based on asset’s book value. Book value of the asset is multiplied by depreciation rate. Book value is calculated by deducting accumulated depreciation from the asset’s cost.

  • Straight line depreciation method maximizes net income by lowering depreciation expense. On the other hand, Reducing Balance Method minimizes net income. For these reasons, companies use Straight line depreciation method in financial statements and use Reducing Balance Method on their tax return.

Under Straight Line Method of depreciation, cost of a tangible asset is equally spread over the useful life. It matches with revenues when the use of the asset is reasonably uniform throughout the service life. It is also useful for the asset which has no particular pattern to the manner in which the asset is to be used over useful life. This depreciation method is used for depreciating vehicles.

Under Reducing Balance Method, depreciation is highly charger in early years than later years. It matches higher depreciation expense with higher revenues generated in early years. It also matches lower depreciation expanse with lower benefits received in later years. This method is appropriate for those assets which lose usefulness because of obsolescence. So the method is recommended for an asset which is expected significantly to be more productive in the early life.

It is clear that there are many differences between Straight Line Method and Reducing Balance Method. But the most important point is that the Straight Line Method charges depreciation expanse evenly throughout the asset’s life while Reducing Balance Method charges depreciation highly in early years. For this reason, companies use these methods of depreciation for different types of assets and for purpose.

Answer to the Question no 02

Discounted cash flow is a valuation method by which one can estimates the attractiveness of an investment opportunity or project. It is the best technique to make investment decisions because both the estimated total net cash flows from the investment and the time value of money come under its consideration. The expected total cash flow means the sum of annual cash flow and salvage value at the end of it useful life. In Net present value method all the net cash flow is discounted and then compared with the present value. Difference between the Present value and the discounted cash flows are called NPV. If net present value is equal to zero or positive than decision is to accept the proposal. IRR is often referred as the discount rate that equates the present value of a project’s expected cash flows to the initial amount invested. A project is accepted if the value of DCF is higher than the cost of a project. The purpose of discounted cash flow is to estimate the money we can receive from a project and to adjust with time value of money. There are many variations when we use our cash flows and discount rate in a discounted cash flow.

PV= CF1/ (1+K) 1+CF2/ (1+K) 2+…..

Free cash flow= Operating profit+ Depreciation+ Amortization of goodwill- Capital spending- Cash taxes- Change in working capital.

Advantages:

First, Discounted Cash Flow considers time value of money. We know that money will earn interest if it is deposited. For this fact if we deposit $100 today in a 7% rate of return. After 1 year we will receive $107 (100*1.07). Conversely if we get $93.47 today its value after one year would be 100. As discounted cash flow converts every flow to present than compares with today’s money it helps us to make decision whether we should invest or not. Discounted Cash Flow is the best method of valuation as it produces closest value to an intrinsic stock value. Discounted cash flow depends on future expectations instead of past result. For example: ABC company has 10000 unit sales in 2011, 9000 units in 2012, 12000 units in 2013. DCF will consider only future sales not historical sales.

The discounted cash flow method rely more on fundamental expectation of a business and less by volatile external factors. External factors can have impact on a firm which should be considered but discounted cash flow only focuses on its fundamental expectations.

By using discounted cash flow method a firm can value its components separately as well as whole. For example Analyst uses this method to determine a firm’s current value according to its future cash flows. On the other side by using these investors can gain insights on what drives share value.

Discounted can be used by both equity shareholders. By this method stockholder can simply discount the dividend and the expected selling price of a share to compare it with other company and then make decision about buying share. IRR which is another method of DCF shows the return on the initial money invested. If we invest in a project of $100000 it will show us how much return we can get from the particular investment.

By using IRR it is an easy way to determine and compare the value of several projects under consideration. IRR provides small business owner a picture of which investment would provide the highest probable cash flow. Another advantage of DCF is that it can be used for budgeting purposes. It can give us a quick snapshot of the possible value or savings of buying new equipment in place of repairing old one.

Disadvantage:

Although discounted cash flow has some advantage it has some drawbacks. First, it is highly dependent on the quality of Assumptions. If components such as Discount rates, free cash flow forecasts and perpetuity growth rates are wide than the fair value for the company won’t be accurate. If a firm delivers disappointing quarterly results, if interest rates take a dramatic turn, we will need to adjust our inputs and assumptions. Following the "garbage in, garbage out" principle what we put into it the output will be similar.

Discounted cash flow can give useful result when a company has high level of confidence about future cash flows. It will not work when it is hard to predict sales and cost with much uncertainty. For Example: ABC Company predicts that their sales in year 2 will be 15000 units. It is hard to predict at all. Because it can be fall for several reason. If it fall Discounted cash flow will not give us accurate result.

Discounted cash flow model focuses on Long term value and is not suitable for short term. For example if a firm invest in such a project which has a life time of less than one year. In that case discounted cash flow is not applicable.

Discounted cash flow has another disadvantage; Changes in long term growth rates have massive effect on share valuation. This can be happen in case of interest rate as well. A disadvantage of IRR method is it does not consider the size of project. In IRR cash flows are compared with the capital spending generating cash flows For example, a project with a $100,000 initial investment and forecasted cash flows of $25,000 in the next five years has an IRR of 7.94%, on the other side a project with a $10,000 initial investment and forecasted cash flows of $3,000 in the next five years has an IRR of 15.2%. Using the IRR method makes the smaller project attractive. It ignores that the larger project may produce higher cash flows and higher profits as well.

The discounted cash flow method only concerns with the projected cash flows. But it ignores the possible future costs that can affect profit. For example if we are considering an investment in power loom, future power and maintenance costs might affect profit if power prices fluctuate and maintenance requirements change. Another disadvantage of IRR occurs when an investor has mutually exclusive project that means both project can’t be accepted simultaneously. For example Building a hospital or a commercial complex on a particular land is mutually exclusive project. In this situation, knowing even if they are worth investing is not enough.

Discounted cash flow does not consider any intangible benefit that a firm can experience. Intangible benefit includes subjective and perceptions about accompany that can’t be expressed in dollar. For example a new computer Information system that can produce an intangible benefit of improved customer satisfaction, retention of talent, more innovative etc.

Another disadvantage of discounted cash flow particularly in IRR is that it is satisfied with one rate of return. It occurs when a project has some negative cash flow between other cast flows. For example a project has $5000 in year 1, $6000 in year 2, $(1000) in year 3 it will give us one rate.

Discounted cash has both strength and weakness. Although it has advantages but do have some disadvantages. DCF analysis tries to calculate the value of a firm today, based on forecasted cash flow. But, manually working through all the in this method can be time consuming. Discounted Cash Flow method considers a company as a business. It involves us to think through all the aspects that can have impact on a firm's performance. After all it can be said that it is just a basic analysis used to calculate fair values but it depends on analyst theories how he or she do it.

Reference:

Weygandt J.J., Kimmel P.D. and Kieso D.E. (2009), Accounting principles 9th edition, United States of America: Wiley, p.444 – 448.

Accounting-Simplified (.), Methods of Depreciation, Available at: http://accounting-simplified.com/financial/fixed-assets/depreciation-methods/types.html. Last accessed 9th August, 2014.

Accounting Tools (.), Straight Line Depreciation. Available at: http://www.accountingtools.com/straight-line-depreciation. Last Accessed 9th August, 2014

Accounting Tools (.). Declining Balance Depreciation. Available at: http://www.accountingtools.com/double-declining-balance-depre. Last accessed 9th August 2014 .

Investopedia (.). Depreciation: Straight-Line Vs. Double-Declining Methods. Available at: http://www.investopedia.com/articles/06/depreciation.asp. Last accessed 9th August 2014.

Bryn Harman (.). Top 3 Pitfalls of Discounted Cash Flow Analysis Available at: http://www.investopedia.com/articles/07/dcf_pitfalls.asp#ixzz1gTYVV2P0 Last accessed 9th August 2014.

Macabacus (.) Discounted Cash Flow (DCF) Analysis Available at: https://macabacus.com/valuation/dcf/overview Last accessed 9th August 2014.

Ben McClure (.)DCF Analysis: Pros & Cons Of DCF available at: http://www.investopedia.com/university/dcf/dcf5.asp Last accessed 9th August 2014.

LetsLearnFinance (.) Advantages and Disadvantages of DCF Method Available at: http://www.letslearnfinance.com/advantages-and-disadvantages-of-dcf-method.html Last accessed 9th August 2014.

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