Easy question about depreciation question, actually, studying, around, cannot

hardwork24

To me there seems to be a really easy and obvious explanation for this that I cannot wrap my head around for some reason (maybe too much studying):

Assume:
EBTD is 100
Depreciation is 50
So EBT is 50
EAT @ 50% is 25

After tax cash flow = EAT + depreciation = 25 + 50 = 75

Does this mean that you will actually have more cash ($75 in this case) assuming depreciation expense, than if you had no depreciation (EBTD x EAT @ 50% = 100 x 50% = $50)?

In other words, why do we add back ALL the depreciation when we could add back depreciation net of tax (50 x 50% = 25) to get equivalent cashes of 50 dollars?

bdavi77962

Intuition tells me that cash flow is cash flow (one true amount) regardless of the amount of depreciation you have since it has nothing to do with cash. So I was just wondering why physical cash in the bank is affected by whether or not you have depreciation. I'm sorry but your post still does not align this intuition with this accounting practice.

saulherman Wrote:
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> The different i that of course the cash amounts
> WILL BE different.....
>
> when we deduct depreciation it decreases our TAX
> OUTFLOW which is a cash outflow.
>
> so if we have depreciation vs not having any of
> course there is going to be a difference in the
> cash outflows

joehogue

The cash flow used in this example is the indirect method thus using all relevant non-cash items to determine the actual cash flow.

From the income statement you can see that depreciation was included to determine net income, however, like you pointed out, depreciation is a non-cash entry meaning that you must add it back to determine the true cash flow for the example.

So, to clear up a couple of points. First, there are two methods to determine cash flow, that is the direct method where all actual cash items are used to determine cash flow and the indirect method where all non-cash items are used.

Secondly, if you use the indirect method to determine cash flow,like in this example, then you must sum all relevant non-cash items to net income (25 = net income; 50 = depreciation thus 25 + 50 = 75 = actual cash flow). If you use the direct method then you will have to minus all relevant cash items from revenue.

The direct method and the indirect method will always be the same.

75 in this example is the true cash flow for the firm.

I hope this is a clearer explanation.

Viceroy

I would think a simpler explanation is that you depreciate an asset before taxes. So when it comes to adjusting things to determine you CF, you add the amount that was originally depreciated (which was before taxes).

When it comes to finding out the true cash flow of the firm, you adhere to the law of equilibrium: if you take out $50 before taxes, you add $50 for the adjustment, so that things are "equal."

As Pope pointed out above, depreciation, being a non-cash expense, is added back to represent the proper cash on hand for the firm.

DarienHacker

Having read my explanation again I didn′t address as to whether you have more cash due to the depreciation entry. In essence, you would have more cash when reporting a depreciation entry.

EBITDA = 100 EBITDA = 100
Depreciation = 50 EBIT = 100
EBIT = 50 Tax @ 50% = 50
Tax @ 50% = 25 EAT = 50
EAT = 25

CF = 25 + 50 = 75 CF = 50

The reason why you have a higher cash flow when reporting a depreciation entry is because ultimately you pay less tax due to having more expenses. The 25 difference between cash flows is the difference between how how much tax you pay when you report depreciation and when you don′t report a depreciation entry.

bchadwick

if your worried about this your probably going to fail

bpdulog

Lol. thanks for the encouragement. it was just really bothering me and i was debating whether this . i come from a mathematical background so everything is interconnected and every detail matters. The smallest detail can prove or disprove a powerful theorem, tool, or argument. I've improved though on letting these things slide for the exam since it is impractical to learn everything for this exam.

However, regarding detail, i would recommend that you read every question very carefully on the exam because i have gotten questions wrong because of not understanding every detail in the question.

Thanks everyone though for your responses, I appreciate it.

saulherman Wrote:
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> if your worried about this your probably going to
> fail