186 Corporate Finance
1 234
EBIT 1,000 2,000 3,000 4,000
- Tax @ 35 percent 350 700 1,050 1,400
- Depreciation at
33.3 percent of WDV 1,500 1,000 667 444
Cash flow 2,150 2,300 2,617 3,044
NPV = –4500 + PV of cash flows
= Rs 2572
The total amount of depreciation might be the same in both the cases but there is a timing difference. In
the second case more depreciation is provided in the initial years. This results in a change in NPV
The Tax Benefit of Depreciation
Depreciation is a tax-deductible expense. The higher the depreciation (an expense), the lower will be the
income and hence tax paid on income.
Assume the following data:
Investment = Rs 400
Tax rate = 35 percent
Discount rate = 12 percent
Tax shield = D × T
= 100 × 0.35 = 35
Year Depreciation Tax shield
1 100 35
2 100 35
3 100 35
4 100 35
PV of tax shield = 35 × PVIFA (12,4) = Rs 106.30
If the depreciation were to change:
Year Depreciation Tax shield
1 200 70
2 100 35
3 50 17.50
4 50 17.50
PV of tax shield = Rs 114
Increase in depreciation will result in higher NPV, but reported earnings come down as an expense item
has increased. This may send wrong signals to the stock market resulting in lower stock prices. So there is a
trade off between reported earnings and higher NPV due to higher tax benefits.