What is Cost of Equity? – Meaning, Concept and Formula
February 12, 2025
Reserve requirements are one of the most important features of modern central banking. We hear about reserve requirements almost every day in the media. When central banks like the Fed change these requirements, it is said to have a huge impact on the markets. Liquidity worth billions of dollars is said to be either released […]
The current ratio is the most popularly used metric to gauge the short term solvency of a company. This article provides the details about this ratio. Formula Current Ratio = Current Assets / Current Liabilities Meaning Current ratio measures the current assets of the company in comparison to its current liabilities. This means that the […]
Banks have to lend money in accordance with the amount of reserves that they have on hand. However, there is no way of finding out the exact amount of loans that a bank can give out while still complying with the reserve requirements because taking deposits and making loans happen simultaneously. Therefore, it is impossible […]
In the previous few articles, we have already studied the concept of automation as it related to retail warehouses. However, it is important to realize that warehouses are not the only place in the retail sector where automation is possible. Over the past few years, the usage of technology in the retail space has rapidly […]
Stripe is one of the most prominent start-ups in the world. It does not have the fame or popularity of other start-ups like Uber or Airbnb. However, Stripe has achieved an equivalent amount of success. In fact, as of early $2022, this start-up company was valued at $95 billion! This stupendous valuation makes it one […]
Depreciation is an important concept in capital budgeting. This is because it is a non cash expense and ideally should not have any effect on the cash flows. This is the reason why it is added back during cash flow calculations.
Since the amount of depreciation never actually left our bank account in the form of expenses, we still have it in cash. So prima facie, it may appear like depreciation had no effect whatsoever. First, we deducted it while calculating the net income in the income statement. Then we added the same amount back while calculating cash flows, thus nullifying its effect.
However, there is more to depreciation. Depreciation affects cash flows in an indirect manner. The effect of the same has been described in this article.
It is true that depreciation is a non cash expense. However depreciation is tax deductible. So the amount of depreciation we pay affects the amount of taxes we pay. Remember while calculating net income we remove the depreciation and amortization figure from EBIDTA to arrive at Profit before Tax. This is the amount on which tax is levied and we get the Profit after Tax figure.
Therefore, the higher the depreciation amount, the lower will be the taxable profit and as a result the lower will be the amount paid as tax. Depreciation, therefore indirectly affects the cash flow by reducing the amount of taxes paid and hence a high depreciation may actually have a positive impact on the cash flows!
The exact amount of taxes that were reduced because of depreciation can be calculated. This is known as the depreciation tax shield. Let’s understand this with the help of an example:
With Depreciation | Without Depreciation | |
EBIDTA | $2000 | $2000 |
Depreciation | $500 | $0 |
PBT | $1500 | $2000 |
Tax @ 40% | $600 | $800 |
PAT | $900 | $1200 |
Now, as we can see that when we consider depreciation the tax paid is lower by $200 i.e. we pay $600 in taxes as opposed to $800. Therefore, $200 is the tax shield. However, we need not go through the entire calculation to come up with the amount of the tax shield.
The calculation can be simplified. We can consider that for every $1 that we have in depreciation, we have saved $0.40 in taxes. Thus to find out the amount of the tax shield all we need to do is multiply the amount of total depreciation by the ongoing tax rate.
Consider for example $500 * 0.40. This is equal to $200, which is the exact amount we derived from the lengthy calculation above.
We need to understand that the tax shield amount will vary with the depreciation amount.
So, accelerated depreciation methods will provide a higher tax shield upfront as compared to straight line methods. Also, since we are going to discount the values of these tax shields, the concept of time value of money applies. It is for this reason that accelerated method of depreciation will be preferred to straight line methods.
Your email address will not be published. Required fields are marked *