Question

Discuss briefly and comment for accuracy the following statements.

“All else equal, higher depreciation expenses will result in larger FCF and lower net income. The specific impact can be discerned by multiplying the incremental depreciation expense by tax rate.”

Answer 1

The given statement is true. Higher depreciation will result in larger FCF and lower net income. This is due to the fact that Depreciation is a tax deductible expense which is non-cash in nature. Means it is allowed as deduction while calculating taxable income but it does not result in outflow of cash. Since it is allowed as deduction and treated as charge against profit, it decreases the Net Income. But due to no outflow of cash it is added back in net income after tax to calculate FCF. Thus, higher the depreciation, higher will be the deduction, lower will be the net income and higher will be the FCF.
Depreciation is first deducted from before tax income and then added back in after tax income. This is done because Depreciation is tax deductible and helps in saving tax. This specific impact can be discerned by multiplying the incremental depreciation expense by tax rate. This is explained with the help of below example:

	$	$
Sales	100000	100000
Less: Costs	-40000	-40000
Less: Depreciation	0	-10000
Profit before tax	60000	50000
Less: Taxes @ 40%	-24000	-20000
Profit after tax	36000	30000
Add: Depreciation	0	10000
FCF	36000	40000

As we can see increase of depreciation of $10,000 decreased the profit after tax (net income) and increased the FCF. The difference in FCF is $4,000 which can also be discern by multiplying the increased depreciation with tax rate, i.e., 10000*40% = $4,000