Manual for Development Projects - Planning Commission

Chapter 5
ii) Depreciation
result of a discounted flow analysis is the allowance for the return to the entity capital
(interest). If we compute net present worth, we are determining what would be left over
after allowing for some specific rate of return to the entity's own capital, the interest.
When we compute "IRR", this is return to the entity's own capital and, in a sense, is the
interest which that capital earns. Thus, interest is not cost in deriving the cash flow for
financial/economic analysis.
Project appraisal attempts to measure the profitability of all resources devoted to the
project; it is not concerned with the way in which these resources are financed. Interest
is the cost of time (waiting) and discount rate is also supposed to be a measure of the
cost of waiting for future benefits. So interest is automatically allowed for in the
discounting procedure. Since the principal of a loan is used to purchase building and
equipment whose costs are already part of the cash flow, repayment of that principal
would add a cost that had already been charged to the project. It may however be
noted that interest on capital is to be shown in the overall cost of a project.
Depreciation is an accounting concept necessary when accounts are to be prepared for one year
at a time (not prepared as a projection over the life of the project) and must include an allowance
for the capital use during each year. Actually a part of the project's revenue is set aside in an
account labelled "depreciation" to ensure that some revenues are retained to replace capital when
it wears out. Thus, it is neither a cost nor a cash outflow. In fact, to include it as a cost would be
double-counting. So in determining the gross cost-stream for calculating out discounted measures
of project worth we do not include depreciation as a cost or, expressing it in an other way, in
computing the incremental net benefits, we do not deduct from the gross benefits any allowance
for depreciation because the incremental net benefit-stream already allows for the return of capital
(depreciation) over the life of the project. When we discuss cash flow, it is an undifferentiated
combination of:
(a) depreciation or amortization - return of capital
(b)
returns paid for the use of capital, such as, dividends, profits, and the like-returns of
capital.
We do not subtract depreciation as a cost. Yet the internal rate of
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return is a measure of the earning capacity of a project - that is, the return to capital - while net
present worth determines whether a project can earn more than some stated amount of return to
capital. The easiest way to go about illustrating what happens to depreciation is to compute the
benefit-cost ratio, the net present worth, and the internal rate of return of a hypothetical example in
which we analyse a project which does not exactly lose money, but, on the other hand, does not
make money either. In other words, its internal rate of return is zero, its net present worth at zero
discount rate is zero, and its benefit-cost ratio at zero rate of interest is just exactly one. Can we
get our money back? Yes, we can. We spent say Rs 1,200,000 over the five years of the project
and by the end of the fifth year suppose we have received just exactly Rs 1,200,000 back. So we
do not lose any of our capital and we recovered all of our other costs. Did we earn anything on this
project? No both the internal rate of return and the net present worth of this project were simply
zero, and the benefit-cost ratio had to be computed at zero rate of interest to have them come out
to 1. Therefore, return of capital is realized (that is, depreciation is covered and fully accounted
for) when the net present worth of the project at a zero discount rate is zero or greater, when the
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9/23/2010