Consider alternative uses of funds

Oct 13, 2025 by talynt.org 106 views

The Economic Impact of Depreciation: A Case Study of Mohini Ltd.

In today's fast-paced business environment, companies are constantly evolving and adapting to changing market conditions. This can lead to the phasing out of certain products or services, resulting in the obsolescence of associated assets. In the case of Mohini Ltd., the company has a number of machines that were used to produce a product that has been discontinued. This article will explore the economic implications of depreciation on these machines, using the straight-line method of depreciation as a case study.

Depreciation is the decrease in value of an asset over time due to wear and tear, obsolescence, or other factors. It is a key concept in accounting and finance, as it allows companies to reflect the true economic value of their assets on their balance sheets. There are several methods of depreciation, including the straight-line method, declining balance method, and units-of-production method.

The Straight-Line Method of Depreciation

The straight-line method of depreciation is the simplest and most commonly used method. It assumes that the asset will lose its value at a constant rate over its useful life. The formula for calculating depreciation using the straight-line method is:

Depreciation = (Cost of Asset - Residual Value) / Useful Life

In the case of Mohini Ltd., the company purchased a machine six years ago for Rs 5,00,000. The machine is being depreciated using the straight-line method, with a residual value of Rs 50,000 and a useful life of 10 years.

To calculate the annual depreciation of the machine, we can use the formula above:

Depreciation = (5,00,000 - 50,000) / 10 Depreciation = 4,50,000 / 10 Depreciation = 45,000 per year

This means that the machine will lose Rs 45,000 of its value each year, resulting in a total depreciation of Rs 2,70,000 over its 10-year useful life.

The economic impact of depreciation on Mohini Ltd. is significant. The company will need to set aside Rs 45,000 each year to account for the depreciation of the machine. This will reduce the company's net income and increase its tax liability. Additionally, the depreciation of the machine will reduce the company's assets and equity, making it more difficult to secure loans or attract investors.

The opportunity cost of depreciation is the value of the alternative uses of the funds that would have been used to depreciate the machine. In this case, the company could have used the Rs 45,000 each year to invest in new equipment or hire additional staff. This would have increased the company's productivity and competitiveness, resulting in higher profits and a stronger market position.

In conclusion, the economic impact of depreciation on Mohini Ltd. is significant. The company will need to set aside Rs 45,000 each year to account for the depreciation of the machine, reducing its net income and increasing its tax liability. The opportunity cost of depreciation is also significant, as the company could have used the funds to invest in new equipment or hire additional staff. This highlights the importance of considering the economic implications of depreciation when making business decisions.

Based on the analysis above, we recommend that Mohini Ltd. consider the following:

Review the company's depreciation policy: The company should review its depreciation policy to ensure that it is using the most appropriate method for its assets.
Consider alternative uses of funds: The company should consider alternative uses of the funds that would have been used to depreciate the machine, such as investing in new equipment or hiring additional staff.
Monitor the economic impact of depreciation: The company should monitor the economic impact of depreciation on its financial statements and adjust its business decisions accordingly.

Future research directions could include:

Comparing the economic impact of different depreciation methods: A study comparing the economic impact of different depreciation methods, such as the straight-line method and the declining balance method, could provide valuable insights for companies.
Examining the impact of depreciation on company performance: A study examining the impact of depreciation on company performance, such as profitability and market value, could provide valuable insights for investors and analysts.
Developing a framework for evaluating the economic impact of depreciation: A framework for evaluating the economic impact of depreciation could provide a useful tool for companies and investors to make informed decisions.
Frequently Asked Questions (FAQs) about Depreciation

A: Depreciation is the decrease in value of an asset over time due to wear and tear, obsolescence, or other factors. It is a key concept in accounting and finance, as it allows companies to reflect the true economic value of their assets on their balance sheets.

A: There are several methods of depreciation, including:

Straight-line method: This is the simplest and most commonly used method, which assumes that the asset will lose its value at a constant rate over its useful life.
Declining balance method: This method assumes that the asset will lose its value at a decreasing rate over its useful life.
Units-of-production method: This method assumes that the asset will lose its value at a rate proportional to its usage.

A: Depreciation is calculated using the following formula:

Depreciation = (Cost of Asset - Residual Value) / Useful Life

For example, if a company purchases a machine for Rs 5,00,000 and it has a residual value of Rs 50,000 and a useful life of 10 years, the annual depreciation would be:

Depreciation = (5,00,000 - 50,000) / 10 Depreciation = 4,50,000 / 10 Depreciation = 45,000 per year

A: The economic impact of depreciation is significant. It reduces the company's net income and increases its tax liability. Additionally, it reduces the company's assets and equity, making it more difficult to secure loans or attract investors.

A: The opportunity cost of depreciation is the value of the alternative uses of the funds that would have been used to depreciate the asset. For example, if a company could have used the Rs 45,000 each year to invest in new equipment or hire additional staff, the opportunity cost of depreciation would be the value of those alternative uses.

A: Companies can minimize the economic impact of depreciation by:

Reviewing their depreciation policy: Companies should review their depreciation policy to ensure that it is using the most appropriate method for their assets.
Considering alternative uses of funds: Companies should consider alternative uses of the funds that would have been used to depreciate the asset, such as investing in new equipment or hiring additional staff.
Monitoring the economic impact of depreciation: Companies should monitor the economic impact of depreciation on their financial statements and adjust their business decisions accordingly.

A: The tax implications of depreciation are significant. Companies can claim depreciation as a tax deduction, which reduces their taxable income and tax liability. However, the tax implications of depreciation can be complex, and companies should consult with a tax professional to ensure that they are taking advantage of the available tax deductions.

A: Companies can ensure that they are depreciating their assets correctly by:

Maintaining accurate records: Companies should maintain accurate records of their assets, including their cost, residual value, and useful life.
Using the correct depreciation method: Companies should use the correct depreciation method for their assets, based on their specific characteristics and usage.
Consulting with a tax professional: Companies should consult with a tax professional to ensure that they are taking advantage of the available tax deductions and complying with tax laws and regulations.