Question

Suppose two new companies are identical in all ways except that one uses an accelerated depreciation method and the other uses the straight-line method. Initially, which company will have the higher profits? Which will have the higher cash flow? Explain your answers using a simple income statement.

Answer 1

Consider 2 companies A and B, with identical earnings before depreciation, interest and taxes. Assume that both companies depreciate an asset of 150,000. Company A uses accelerated depreciation method (5-year MACRS) and Company B uses straight-line method. Then, for year 1 of depreciation, Company A records a depreciation of 19.2%*150,000 = 28,800 and for year 2, 32%*150,000 = 48,000 while Company B records a depreciation of 150,000/5 = 30,000, each year.

The income statements for year 1 and year 2 are, as follows:

		Year 1		Year 2
Formula		Company A	Company B	Company A	Company B
	EBITDA	500000	500000	500000	500000
	Depreciation (D)	28800	30000	48000	30000
EBITDA-D	EBIT	471200	470000	452000	470000
	Interest (I)	20000	20000	20000	20000
EBIT-I	EBT	451200	450000	432000	450000
EBT*25%	Tax @ 25% (T)	112800	112500	108000	112500
EBT - T	Net income	338400	337500	324000	337500
EBIT*(1-Tax rate)+Dep.	Operating cash flows	382200	382500	387000	382500

As can be observed, net income of Company A is less than the net income of Company B whereas operating cash flows for Company A are higher than that for Company B. This happens because higher depreciation expense reduces net income. However, due to the higher tax shield afforded by depreciation, the operating cash flows increase.