Depreciation and Cash Flows

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bloodline

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I am struggling to conceptualize the relationship between depreciation and cash flows.
Depreciation is a non cash expense that is added back to Net Income in the estimation of cashflows. However, the amount of taxes saved by reporting depreciation expense is totally igonred, why is this the case?
In cash flow terms, if two companies, Company A and B report the same amount of revenue and expenses, but differ only due to the fact company A carries zero depreciation and company B carries X amount of depreciation, then surely, in cash flow terms, there should be no difference between Operating Cash Flow reported by both companies since depreciation is a non cash item, but we all know this is not the case, since company B pays lower taxes than Company A due to the amount of depreciation.
Is it possible then to conclude that even though depreciation does not directly impact on operating cash flows, it does so indirectly via the amount of cash saved from taxes?
sorry for the long post
 
Hello bloodline,
No doubt depreciation is a non cash expense hence it should be added back to the net income to find the cash flow for the company.
The amount saved because 1 of the company reports depreciation is called depreciation tax shield = D*T.
Suppose both companies have $1000 of EBITDA, 0 interest and only company B has $100 of depreciation and the tax applicable to both is 40%. So
For company A -> the cash flow will be 1000*(1-0.4) +0 = 600 + 0 = $600
For company B -> the cash flow will be (1000-100)*(1-0.4) + 100 = 540+100 = 640
Notice that company B has 640-600 = $40 more cash flow. This is the depreciation tax shield which was mentioned as D*T (100*0.4) = $40
Hence depreciation will save $40 of tax the depreciation tax shield (It is somewhat similar to the interest tax shield). So yes there is an indirect effect, because of the lower tax.
Hope that helps.
Have a nice day.
 
Thanks. In this equation, why then do we add back after tax Interest but before tax depreciation? assuming depreciation is the only non cash charges?
FCFF = NI + NCC + Int(1− Tax rate)− FCInv − WCInv
 
Remember that you are trying to calcualte the cash available :
Depreciation is actually not paid out so it is added back; The tax saving (depreciation shield) is saving for the company and you can’t deny the cash that is there. See it with the above example -> You have 1000 cash but you have assumed 100 depreciation so now you have 900*0.6 + 100 = 640 cash
however Interest is an actual outflow so suppose this example was for interest then 1000 cash - 100 interest = 900, after tax the cash left is 540;
If interest was not there then the cash would have been 600.
So effectively you gave out only 60 as interest as compared to the situation when you dont give interest. Hence after tax interest expense = 60 and not 100.
Life would be much simpler if you just remember the after tax interest rate = rd*(1-tax)
The difference is that in depreciation the outflow is not there - think of it as putting money in the other pocket then giving out tax then add both the pockets’ money.
In interest you give out 100 so after tax you are left with 540 so if you want to go back to no interest you dont add 100 but only 60. Basically the tax benefit here is on the money given out. The value of cash cant exceed the value if there was not interest given out (For cash position it can’t be worse to give no interest at all than to give interest)!
 
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