Does increased depreciation increase or decrease your valuation?
Does increased depreciation increase or decrease your valuation? Thank you any response would be helpful. I'm assuiming increase due to tax savings
You can test using a very simple case.
Company with cash flows in year 1 only. No debt (so no interest), and no change in working capital items.
Valuation = FCF_Y1 / (1 + r)
- (only depends on FCF)
Now,
FCF = NOPAT – Capex + depreciation – net change in NOWC
If depreciation increases by $10 (say tax 40%).
Operating profit = down by $10
Tax saving = $4
Net income = down by $6
Incremental change in FCF = change in EBIT*(1-t) – change in (Capex - Depreciation) – net change in NOWC
= -10 * (1 – 40%) – 0 + 10 – 0
= -6 + 10
= 4
Hence, FCF increased. Thus, the valuation increased.
So, yes. The tax saving increases the valuation. I tested it in a recent 3-statement model as well and the price increased.
However, this assumes nothing else changes. You probably have to be careful in special situations. Like if the company needs additional capital for CapEx or something but is in financial distress, just increasing the depreciation might not elevate value. I will have to think about it in more detail. It's past midnight and my cognition is not at peak right now.
Ah, you're on the right track! Increased depreciation can indeed lead to an increase in the company's valuation, but it's a bit of a balancing act. Here's why:
When depreciation increases, it reduces the company's net income on the income statement due to the higher expense. However, because depreciation is a non-cash expense, it gets added back in the cash flow statement, which increases the cash flow from operations.
Now, here's where the tax savings come in. The decrease in net income also means a decrease in taxable income, which in turn leads to lower taxes. This tax shield (the reduction in taxes) effectively increases the cash flows, which could lead to a higher company valuation.
But remember, this is a simplified explanation. In reality, the impact of increased depreciation on a company's valuation can be influenced by a number of other factors, including the company's tax rate, its capital structure, and the methods it uses for depreciation. So, while the basic principle holds true, the actual impact can vary.
Keep up the good work! Understanding these nuances is key to mastering finance.
Sources: Got asked this question in an interview, Today's Investment Banking Interview Question?, https://www.wallstreetoasis.com/forum/investment-banking/advance-payments-and-valuation-of-a-firm?customgpt=1, 21 Finance Interview Questions and Answers
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