Why does cash increase, not decrease, when depreciation increases, assuming a positive tax rate?
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The answer
Depreciation itself costs no cash, but it lowers taxable income, so a company pays less in cash taxes. Because taxes are a real cash expense, that tax saving is a net cash inflow. For example, assuming a 25% tax rate, a $10 depreciation increase reduces taxes owed by $2.50, boosting cash by that amount. Net income falls by only the after-tax amount, $7.50, because the tax bill is lower.
On the cash flow statement, I add back the full $10 of depreciation to net income, since it is non-cash, which yields a net cash gain of $2.50. That is the tax shield at work: a larger non-cash deduction means the company actually keeps more cash, even though book earnings take a smaller hit. So cash goes up, not down, precisely because depreciation is a non-cash expense that shelters real cash taxes.
Income statement
| Revenue | 1,000 |
| COGS | (600) |
| Gross profit | 400 |
| SG&A | (180) |
| EBITDA | 220 |
| D&A | (40) |
| EBIT | 180 |
| Interest expense | (20) |
| Pre-tax income | 160 |
| Taxes | (40) |
| Net income | 120 |
Also asked as
- Depreciation increases by $10 with a 25% tax rate. Walk through the impact on the income statement, cash flow statement, and balance sheet, and confirm the balance sheet balances.
- By how much does net PP&E fall when depreciation increases by $10: the full $10 or the after-tax amount? Explain why.
- What happens to EBITDA when depreciation increases? Explain why, referencing the definition of EBITDA.
- If a company has no current cash tax liability (e.g., due to net operating loss carryforwards), what is the cash flow statement effect of a $10 increase in depreciation?
- Explain why companies often use different depreciation methods for book purposes versus tax purposes, and what balance sheet item captures the difference.
- A company's depreciation increases by $10 for the year with a 25% tax rate, and this is a recurring annual charge from an asset with 4 years of remaining useful life. Describe how the net income, cash, and balance sheet effects evolve over those 4 years and what happens in year 5.
- A company's net income fell by exactly $9 year-over-year, and the only change was an increase in depreciation expense, with a 25% tax rate. Determine the pre-tax increase in depreciation, then walk through the full impact on all three statements.
- A company buys $80 of equipment at the start of the year, funding $50 with cash and $30 with new debt at 6% interest, depreciated straight-line over 8 years. Tax rate 25%. Walk through the full first-year impact on all three statements and confirm the balance sheet balances.
- A company's tax depreciation exceeds its book depreciation by $12 this year due to accelerated tax depreciation, with a 25% tax rate applying to both book and taxable income. Explain what balance sheet account absorbs this difference, in which direction it moves, and how the cash flow statement effect differs from the simple book-depreciation tax shield calculation used elsewhere in this lesson.
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The rest of this topic
Depreciation, write-downs and the tax shield