How does depreciation affect the calculation of a project's payback period?

• A. Depreciation does not affect the payback period because it is a non-cash expense.
• B. Depreciation shortens the payback period by increasing cash flows.
• C. Depreciation is included in the payback period calculation as a cash outflow.
• D. Depreciation increases the payback period by reducing net income.

Answer: (A)

Verified step by step guidance

1. Understand the concept of depreciation: Depreciation is a non-cash expense that represents the allocation of the cost of a tangible asset over its useful life. It does not involve actual cash outflows or inflows.
2. Understand the payback period: The payback period is the time it takes for a project to recover its initial investment through cash inflows. It focuses solely on cash flows, not accounting measures like net income.
3. Analyze the relationship between depreciation and cash flows: Since depreciation is a non-cash expense, it does not directly affect cash inflows or outflows. Therefore, it does not impact the calculation of the payback period.
4. Clarify common misconceptions: Depreciation may reduce net income for accounting purposes, but this reduction does not affect the cash flows used in payback period calculations. Cash flows are calculated independently of non-cash expenses like depreciation.
5. Conclude: Depreciation does not affect the payback period calculation because it is excluded from cash flow analysis. The payback period focuses solely on cash inflows generated by the project.