Which one of the following statements is true?Accounting profit and cash flow are the same thingAll else equal, an increase in the tax rate, increases the value of depreciation tax-savingsInvestments in net working capital are examples of sunk costsOperating costs are part of opportunity costsIf the same amount of net working capital is recovered at the end of the project as was invested initially, than its impact on NPV is positive because the discount rate used is positive
Question
Which one of the following statements is true?Accounting profit and cash flow are the same thingAll else equal, an increase in the tax rate, increases the value of depreciation tax-savingsInvestments in net working capital are examples of sunk costsOperating costs are part of opportunity costsIf the same amount of net working capital is recovered at the end of the project as was invested initially, than its impact on NPV is positive because the discount rate used is positive
Solution
The statement "All else equal, an increase in the tax rate, increases the value of depreciation tax-savings" is true.
Here's why:
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Depreciation is a non-cash expense that reduces a company's taxable income. The lower the taxable income, the lower the taxes a company has to pay.
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When the tax rate increases, the value of the depreciation tax shield (the reduction in taxes due to depreciation) also increases. This is because the company is able to deduct more from its taxable income, thus saving more on taxes.
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Therefore, all else being equal, an increase in the tax rate increases the value of depreciation tax-savings.
The other statements are not necessarily true:
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Accounting profit and cash flow are not the same thing. Accounting profit is a company's total revenue minus its explicit costs. Cash flow, on the other hand, refers to the net amount of cash and cash-equivalents being transferred into and out of a company.
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Investments in net working capital are not examples of sunk costs. Sunk costs are costs that have already been incurred and cannot be recovered. Investments in net working capital, however, can be recovered.
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Operating costs are part of opportunity costs. This is not always true. Opportunity costs refer to the potential benefits an individual, investor, or business misses out on when choosing one alternative over another. While operating costs can be part of opportunity costs, they are not always.
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If the same amount of net working capital is recovered at the end of the project as was invested initially, then its impact on NPV is not necessarily positive because the discount rate used is positive. The impact on NPV depends on the timing of the cash flows, not just the discount rate.
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