Corporate Finance

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.