Cost of Depreciation-Generated Funds - Financial Management

One large source of funds for many firms is funds generated from depreciation. Of course, depreciation per se does not generate cash. Rather, depreciation is simply a noncash expense charged against income the amount of cash flow generated by the firm during a given time period. To adjust net income for the cash flow effect of depreciation, the amount of depreciation must be added to net income after taxes. It is in this sense that depreciation represents a source of funds. Also, some firms may generate funds from the sale of assets from time to time.What is the cost of these funds? Because the firm always has the option to either reinvest these funds in the firm or to return them to the stockholders as dividends and to retire outstanding debt, the appropriate opportunity cost of these funds is the firm’s weighted (marginal) cost of capital, before considering new stock issuance costs.

Determining the optimal capital budget

With respect to the marginal cost of capital schedule in Figure, it is generally agreed that these funds have an opportunity cost equal to the first “block” of funds, that is, 10.96 percent. If $10 million in depreciation -generated funds were available, the first block of funds would increase from $12.5 million to $22.5 million, and all other blocks would also be shifted to the right by $10 million.

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