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.

Depreciation and Taxation

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!

Depreciation Tax Shield

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:

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.

Shortcut to Determine 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.