Write Down of PPE by 100
May seem like a basic question, but still confused. Let's say PPE is written down by 100. EBIT will decrease by 100, and after tax effect is -60 on NI. Once we move to cash flow statement, we add back the 100, and we have a net change of +40 cash.
But let's just stop and think about it. Does a PPE write off really increase cash? My point of confusion is that we should also take into account the DTA that is created when our book pre tax income is lower than our taxable income. In this case, the DTA created is 40, instead of cash going up by 40.
Let me see if I can answer this without even addressing DTA. All these types of questions involving the effect of an additional line item flowing through the financial statements can be misinterpreted in how that will increase/(decrease) cash. Since the income statement and cash flow statement are 'change' statements, meaning they correspond with the transactions that occur over a period (contrasted with the balance sheet which is a position statement), the cash effect answer to these questions is not a change, persay. Rather, it's a 'change in-the-change' of cash over that period.
It seems like an obscure difference, but saying that the net change in cash increased by 40 is not the same as saying your cash increased by 40. The answer to this question is simply suggesting that all else held constant, an additional $100 write-down will decrease earnings, but also means $100 less that taxes will be paid on, such that $40 is saved that would otherwise have been paid in taxes.
So you are absolutely right, cash is not "increasing". Instead, the change in cash is increasing.
Better described as "Incremental Free Cash Flow Analysis"
Where you don't actually need to know what the IS / BS / FCF values are. Only what the net effect of changing one or a handful of things would yield.
Sorry to belabor the point, but I guess what I'm going at is that you are still paying cash taxes on the original taxable income, not the new amount that is reduced by 100 ppe write off. So we're not saving any cash at all in reality, if that makes sense.
I think I see what you're saying. That's probably great to know, but I would just keep it in your back pocket during an interview unless it gets brought up. I'd imagine that would open a whole new can of worms if you answered like that haha
Best way to think about it is to relate it to depreciation.
If Depreciation were to increase by $10, then:
IS: Pre-tax income down 10 Net Income Down 6
CF: Net Income Down 6 Add back D&A 10 Net Change: 4 (+)
BS: Cash Up 4 PP&E Down 10 (because our fixed assets are "worth" less from Depreciation) Equity Down 6 because of Net Income Balances.
Why do we ADD back Depreciation? Because it is non-cash. What does non-cash mean?? Depreciation was invented by accountants because they needed to find a way to reduce the value of fixed assets over time (since things lose value/usefulness over time). Hence Depreciation was invented - it is an expense. Expenses are subtracted in the income statement as they reduce profitability. Think about it though.. when we create the journal entry (Dr Dep Expense / Cr Acc Dep) we are creating an expense, but we are not actually paying anyone CASH. We are simply recording an expense because we recognize that our fixed assets are decreasing in value. THAT is why we add back, because no money ever left our pockets - it's a pure accounting thing.
Now, onto a $100 write off of PP&E.
Things to note: An ASSET WRITE DOWN = REPORTED AS A LOSS ON IS A LIABILITY WRITE DOWN = REPORTED AS A GAIN ON IS
Therefore, the write down of PP&E is reported as an expense on the income statement which reduces profitability. Why do we ADD BACK the write down? Because we haven't spent any cash per se; we've just recognized that because of some factor, our PP&E are now worth 0, but in essence, we haven't actually "paid" anything. Cash increases due to the amount of money we save on taxes thanks to a reduced taxable income figure - purely mechanical.
Hope this makes sense.
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