CFA Level 1: Comparison of Operating Cash Flow under Capitalization and Expensing

Comparison of Operating Cash Flow under Capitalization and Expensing

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Question

A firm has legal cash expenses of 300 and a tax rate of 40. If it chooses to capitalize the costs and depreciated them over 3 years, the operating cash flow under capitalization, compared to that under expensing, will be ________.

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A. B. C. D.

C

Under expensing, the operating cash flow will be reduced due to this expense by 300*(1-0.4) = 180 (there is an outflow of 300 but since the expenses are tax deductible, taxes on total income get reduced by 120). Instead, if the firm capitalized the expense, an asset value of 300 will be generated. The entire expense will be charged against investing cash flow. Depreciation of capitalized expense leads to a depreciation expense of 300/3 = 100. This will reduce taxes paid by

100*0.4 = 40. Thus, capitalization leads to an increase in the operating cash flow of 40. In summary, expensing reduces the expense by 180 while capitalization increases operating cash flow by 40. Thus, operating cash flow under capitalization is larger by 40 - (-180) = 220.

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