What is depreciation and how does it relate to CAPEX?

What is depreciation and how does it relate to CAPEX?

• A. Depreciation is the cash flow generated by assets; it increases CAPEX.
• B. Depreciation is the process of acquiring more assets quickly; it reduces CAPEX.
• C. Depreciation is the gradual loss of value of fixed assets over time; it affects accounting and tax implications for CAPEX.
• D. Depreciation is the market price change of a commodity.

Answer: (C)

Depreciation is the gradual loss of value of fixed assets over time. In relation to CAPEX, it’s the way you allocate the cost of a long-term investment over its useful life for accounting and tax purposes. When you make a capital expenditure, the asset’s cost isn’t expensed all at once. Instead, you capitalize it and depreciate it each year, which lowers reported income and creates a tax shield. This reduces taxes and affects after-tax cash flow, even though the actual cash outlay occurred at the time of purchase. For example, a 1,000,000 asset with a 10-year life might show 100,000 of depreciation each year, spreading the cost over time. Depreciation doesn’t represent new cash flow and isn’t about changing market prices; it’s the accounting method that reflects asset wear and tax effects on CAPEX decisions.

Depreciation is the gradual loss of value of fixed assets over time. In relation to CAPEX, it’s the way you allocate the cost of a long-term investment over its useful life for accounting and tax purposes. When you make a capital expenditure, the asset’s cost isn’t expensed all at once. Instead, you capitalize it and depreciate it each year, which lowers reported income and creates a tax shield. This reduces taxes and affects after-tax cash flow, even though the actual cash outlay occurred at the time of purchase. For example, a 1,000,000 asset with a 10-year life might show 100,000 of depreciation each year, spreading the cost over time. Depreciation doesn’t represent new cash flow and isn’t about changing market prices; it’s the accounting method that reflects asset wear and tax effects on CAPEX decisions.