What does it really mean if a company's depreciation increases and how does it affect the valuation?

I got asked this question on a first round investment banking interview. This is not the same as walk me how a $100 increase in depreciation affects the three statements.

I know that your pre-tax income falls which reduces your net income. But what else can you say?

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Comments (7)

Oct 9, 2017

my guess would be that the valuation would be lower assuming that the depreciation increase is tied to a capex increase (and not just an increase in depreciation you realize that year b/c you depreciated an asset using MACRS or something like that). you add back depreciation because it's non cash but depreciation is tied to CapEx which is a cash expense. my thinking might be off, though

Best Response
Oct 9, 2017

Yeah. It means that the company is a) changing its useful life expectations on historical and anticipated capex, which will increase replacement costs, lower FCF, and hurt valuation, or b) the company is upping capex to accelerate growth or increase margins, which taken together could increase FCF and boost valuation.

Oct 9, 2017

Wouldn't this increase the valuation? It would reduce your net taxable income (depreciation tax shield) ergo reduce cash outflows to the government? You're adding that depreciation back into your yearly FCF number since it's a noncash expense. Maybe I'm missing something here.

Oct 9, 2017

Not really, for two reasons. One, not every investor is backing out non-cash charges to gaap EPS before applying a multiple. But more importantly, depreciation doesn't increase in a vacuum. If it goes up, it is probably because capex is going up also, and the valuation impact will depend on whether that's growth or maintenance capex.

Oct 10, 2017

Wouldn't the caveat be if you pretend the only thing changing is which depreciation method you're using?

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Oct 10, 2017

Ya I assume that's what they were looking for, just depreciation.

Oct 10, 2017