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  1. 039Depreciation rises by Rs 10 and the tax rate is 25%. Walk the change through net income, the cash flow statement and the balance sheet.Valuation, accounting and macro riddlesWarm upMillennium ManagementNew York · 2024

    Try it first

    What happens to cash?

    Show the worked solution

    Net income falls Rs 7.5, cash rises Rs 2.5 and the balance sheet shrinks by Rs 7.5 on both sides. Pre-tax profit falls 10, tax falls 2.5, so net income falls 7.5. The cash flow statement starts at -7.5 and adds back the non-cash 10: cash up 2.5. On the balance sheet, cash is up 2.5 and fixed assets are down 10, so assets fall 7.5, matched by retained earnings down 7.5.

    Why does cash go up when an expense goes up?

    Imagine your employer lets you deduct the wear on your car from taxable income. No money leaves your pocket for the wear itself, but your tax bill falls. Depreciation is an expense that costs no cash but reduces tax, so the only cash effect is the tax saved: 25% of Rs 10, Rs 2.5. That is the {term('depreciation tax shield', 'The tax saved because depreciation is deductible even though it uses no cash; equal to depreciation times the tax rate.')}, and it is the one number the question is testing.

    Depreciation up Rs 10 at a 25% tax rate, through all three statementsIncome statementDepreciation+10.0Pre-tax profit-10.0Tax-2.5Net income-7.5Cash flow statementNet income-7.5Add back depreciation+10.0Cash from operations+2.5Change in cash+2.5Balance sheetCash+2.5Fixed assets-10.0Total assets-7.5Retained earnings-7.5Assets -7.5 = liabilities 0 + equity -7.5: it balancesCash rises by the tax saved, 25% of 10, because depreciation is a non-cash expense that cuts tax
    A Rs 10 rise in depreciation at a 25% tax rate cuts net income by Rs 7.5, raises cash by Rs 2.5 through the tax saved, and lowers fixed assets by Rs 10, so total assets and retained earnings both fall by Rs 7.5 and the balance sheet balances.

    What order do you walk it in so nothing gets lost?

    Income statement first, then cash flow, then balance sheet, one line each. Net income is the bridge: it closes the income statement, opens the cash flow statement, and lands in retained earnings on the balance sheet. Income statement: depreciation +10, pre-tax -10, tax -2.5, net income -7.5. Cash flow: -7.5 plus 10 added back, cash +2.5. Balance sheet: cash +2.5, fixed assets -10, so assets -7.5; retained earnings -7.5, so the two sides move together.

    Add one sentence on why a hedge fund analyst cares. Two companies with identical operations can report different earnings because of depreciation choices, while their cash generation differs only by the tax effect. That is one reason investors look at cash flow alongside earnings before trusting a P/E.

    Where candidates lose it

    The common loss is saying cash is unchanged because depreciation is non-cash. That forgets the tax: depreciation is deductible, so the tax bill falls and cash rises by Rs 2.5.

    The second loss is saying cash falls 7.5 by reading net income as cash. Walk the add-back out loud and check that assets and equity both fall by 7.5 before you stop.

    What the interviewer asks next

    • Now the depreciation rise comes from a Rs 10 write-down of an asset that is not tax deductible. What changes?
    • What if the company is loss-making and pays no tax this year?
    • Walk a Rs 10 rise in inventory, bought with cash, through the three statements.

    Asked at Millennium Management, Investment Research, New York, 2024 (Wall Street Oasis): Nothing as much, technical questions were super basic like $10 depreciation