Question

When we adjust operating income (EBIT) after re-categorizing R&D as a capital expenditure instead of as an operating expense, we add on an ignored tax benefit to get our after-tax operating income EBIT(1-T). However, when we adjust EBIT after re-categorizing operating leases as a financing expense or debt, we do not add on an ignored tax benefit to our after-tax operating income EBIT(1-T). Why is that?

Answer 1

Let me know if you need any clarification..

Project evaluation is based on Weighted average cost of capital which include the cost of equity, preferred share and debt.

so we evaluate the free cash flow before making any payment to these capital owner or in other word we don't take into account dividend, preferred dividend or interest on debt. Because WACC include the required rate of discounted.

So when we re-categorize R&D expenses as capital expenses, we will be eligible for the tax benefit on depreciation. Therefore after tax operating cash flow is adjusted toward the non cash expenses for capitalization.

But when we re-categorizing operating lease as financial lease (means debt) we will adjust the required rate of return or Discounting rate and not the cash flows.