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.