Financial Management: Meaning, Scope, Objectives & Functions
Meaning of Financial Management Financial Management means planning, organizing, directing and controlling the financial activities such as procurement and utilization of funds of the enterprise. It means applying general management principles to financial resources of the enterprise. Scope/Elements of Financial Management Investment decisions includes investment in fixed assets (called as capital budgeting). Investment in current […]
Managing Money Laundering Risks in Commercial Banks
Up until now, we have seen various ways in which commercial banks are able to serve their corporate clients. Almost all the products and services created by commercial banks are created with the intention to serve their customers. However, corporate customers are not the only stakeholders that the banks have. Commercial banks are also answerable […]
Lease Rental Discounting
Many corporations and individuals earn a significant portion of their income from rents that they derive from their immovable properties. The financing needs of these people are different from the vast majority of the population. It is for this reason that special products like lease rental discounting have been created to meet their needs. In […]
The Socialization of Losses
Joseph Stiglitz is one of the most renowned economists of our time. He once criticized the current economic system after the great recession of 2008. He said that the current system is skewed in favor of the rich. This economic system is no longer capitalism. It is a strange combination of capitalism and socialism wherein […]
Managing Assumptions During Financial Modelling
Making assumptions is an integral part of every financial calculation. It is a known fact that if the assumptions are modified even slightly, the numbers on the model tend to change dramatically. The problem is that financial modeler is forced to make several assumptions while creating the model. When several of these assumptions are being […]
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.
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