Foundations of Financial Management: An Analysis (part 7)

Do you know the only thing that gives me pleasure? It's to see my dividends coming in.

John D. Rockefeller

Review of Accounting (part D)

by

Charles Lamson

Depreciation and Cash Funds Flow

One of the most confusing items to people learning about finance is whether depreciation is a source of funds to the corporation. In Table 1 (see below), which was presented in the last post, we listed depreciation as a source of funds (cash flow). This item deserves further clarification. The reason why we added back depreciation was not that depreciation was a new source of funds, but rather that we subtracted this noncash expense in arriving at net income and now have to add it back to determine the amount of actual funds on hand.

Table 1 Cash flows from operating activities

Depreciation represents an attempt to allocate the initial cost of an asset over its useful life. In essence, we attempt to match the annual expense of plant and equipment ownership against the revenues being produced. Nevertheless the charging of depreciation is purely an accounting entry and does not directly involve the movement of funds. To go from accounting flows to cash flows in Table 1, we restored the noncash deduction of $50,000 for depreciation that was subtracted in Table 2 (see below), the income statement, which was presented in Part 4 of this analysis.

Table 2

Let us examine a simple case involving depreciation in Table 3. Assume we purchase a machine for $500 with a five-year life and we pay for it in cash. Our depreciation schedule calls for equal annual depreciation charges of $100 per year for five years. Assume further that our firm has $1,000 in earnings before depreciation and taxes, and the tax obligation is $300. Note the difference between accounting flows and cash flows for the next two years in Table 3.

Table 3 Comparison of accounting and cash flows

Since we took $500 out of cash flow originally (year 1) to purchase equipment (in column B above), we do not wish to take it out again. Thus we add back $100 in depreciation (in column B) each year to "wash out" the subtraction in the income statement. 

Free Cash Flow 

Free cash flow (FCF) is actually a byproduct of the previously discussed statement of cash flows presented in the last post (Table 4 below). Free cash flow is equal to the value shown under Table 3.

Table 4

The concept of free cash flow forces the stock analyst or banker not only to consider how much cash is generated from operating activities, but also to subtract out the necessary capital expenditures on plant and equipment to maintain normal activities. Similarly, dividend payments to shareholders must be subtracted out as these dividends must generally be paid to keep shareholders satisfied.

The balance, free cash flow, is then available for special financing activities. In the last couple decades special financing activities have often been synonymous with leveraged buyouts, in which a firm borrows money to buy its stock and take itself private, with the hope of restructuring its balance sheet and perhaps going public again in a few years at a higher price than it paid. Leveraged buyouts are discussed more fully later in this analysis. The analyst or banker normally looks at free cash flow to determine whether there are sufficient excess funds to pay back the loan associated with the leveraged buyout. 

Income Tax Considerations

Virtually every financial decision is influenced by federal income tax considerations. Primary examples are the lease versus purchase decision, the issuance of common stock versus debt decision, and the decision to replace an asset. While the intent of this section is not to review the rules, regulations, and nuances of the federal income tax code, we will examine how tax matters influence corporate financial decisions. The primary orientation will be toward the principles governing corporate tax decisions, though many of the same principles apply to a sole proprietorship or a partnership. 

Corporate Tax Rates

Basically, the corporate federal tax rate is progressive, meaning lower levels of income are taxed at lower rates (Block & Hirt, 2005, p. 40). Higher levels of income are taxed at higher rates. In the illustrations in this analysis, we will use various rates to illustrate the impact on decision making. The current top rate is 21 percent, down from 35 percent by the 2017 Tax Cuts and Jobs Act (Tax Policy Center Briefing Book). However, keep in mind that corporations may also pay some state and foreign taxes, so the effective rate can get higher in some instances.

Cost of a Deductible Expense

The business person often states that a tax-deductible item, such as interest on business loans, travel expenditures, or salaries, cost substantially less than the amount expended, on an after-tax basis. We shall investigate how this process works. Let us examine the tax statements of two corporations---the first pays $100,000 in interest, and the second has no interest expense. Let's use the current top corporate tax rate of 21 percent.

Although Corporation A paid out $100,000 more in interest than Corporation B, its earnings after taxes are only $79,000 less than those of Corporation B. Thus we say the $100,000 in interest cost the firm only $79,000 in after-tax earnings. The after-tax cost of a tax-deductible expense can be computed as the actual expense times 1 minus the tax rate. In this case, we show $100,000 (1 - tax rate), or $100,000 * .79 = $79,000. The reasoning in this instance is that $100,000 is deducted from earnings before determining taxable income, thus saving $21,000 in taxes and costing only $79,000 on a net basis.

Because the dividend on common stock is non tax-deductible, we say it cost 100% of the amount paid. From a purely corporate cash flow viewpoint, the firm would be indifferent between paying $100,000 in interest and $79,000 in dividends.

Depreciation as a Tax Shield

Although depreciation is not a new source of funds, it provides the important function of shielding part of our income from taxes. Let us examine corporations A and B again, this time with an eye toward depreciation rather than interest. Corporation A charges off $100,000 in depreciation, while Corporation B charges off none.

We compute earnings after taxes and then add back depreciation to get cash flow. The difference between $337,000 and $316,000 indicates that Corporation A enjoys $21,000 more in cash flow. The reason is that depreciation shielded $100,000 from taxation in Corporation A and saved $21,000 in taxes, which eventually showed up in cash flow. Though depreciation is not a new source of funds, it does provide tax shield benefits that can be measured as depreciation * the tax rate, or in this case $100,000 * .21 = $21,000. A more comprehensive discussion of depreciation's effect on cash flow is presented later in this analysis, as part of the long-term capital budgeting decision. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 37-42*

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