CPAs within corporate accounting departments are often called upon to develop a future cash-flow schedule of the business’s operations for use in a discounted cash-flow valuation model. When preparing a future cash-flow schedule, special consideration should be given to the depreciation expense used in the model. The depreciation expense can affect the projected income tax expense and thus the amount of projected cash-flow to
the owners.

Calculating Depreciation Expense

There are two ways to calculate depreciation expense. They are:

• Economic depreciation. This method is based on the estimated useful life of the asset and uses financial reporting; and
• Income tax depreciation. This is based on Internal Revenue Service guidelines and is used to prepare the company’s income tax returns.

A typical discounted cash-flow (DCF) valuation model uses a short-term discrete period of (normally) five to 10 years, and a terminal period represents cash-flow into perpetuity. The objective of a future cash-flow schedule is to forecast, as best as possible, the anticipated cash-flows generated from operations. Thus, a future cash-flow schedule should anticipate the depreciation expense to be used for income tax purposes. The expected tax depreciation will affect taxable income, which will affect the income tax expense, which will ultimately impact the cash-flow.

Many valuation analysts employ depreciation schedules provided by management for financial reporting purposes, and not for income tax purposes. It is therefore important for management or a valuation analyst to recognize and understand the difference. There are certain accelerated depreciation methods allowable for tax purposes that a company may have previously elected, and these depreciation rates will dictate the income tax expense. However, the terminal year cash-flow component of the DCF model should utilize the economic depreciation of an enterprise’s fixed assets. Because valuation analysts commonly believe that depreciation will approximate capital expenditures into perpetuity, depreciation expense in the terminal year is determined based on estimated annual capital expenditures.

Impact of Economic Stimulus Act of 2008

In addition to depreciation elections on existing equipment, depreciation expense related to future capital expenditures should also be considered. The Economic Stimulus Act of 2008 contains provisions that enable a business to obtain larger tax deductions on qualified property that is placed into service in the first year. The Act increased the dollar limitation on the amount of tangible personal property that can be taken as a current tax deduction under Section 179 of the Internal Revenue. The maximum deduction which may be taken under this election for property placed in service during a year beginning in 2008 is $250,000. Unless changed by future legislation, the maximum amount will drop to $128,000 (plus an inflation adjustment) after 2008 and to $25,000 after 2010.

Example: Suppose a company is projecting $350,000 in capital purchases in year three, a company can elect Section 179 and expense the first $128,000 and depreciate the remaining $222,000 based on the maximum amount allowed for income tax purposes (See Table 1). If Section 179 deductions were not applied as illustrated and the total amount of the capital expenditure was depreciated (in this case, 10-year amortization), the resulting cash-flow would be less than if the Section 179 deduction were assumed (Table 2). The resulting present value of the cash-flows utilizing Section 179 is $6.8 million, while the present value of the cash-flows applying normal depreciation is $6.7 million. The difference may be more pronounced if capital expenditures were larger compared to operating income.

The Economic Stimulus Act also included a provision for additional first-year “bonus” depreciation of 50 percent of the adjusted basis of qualifying property purchased and placed in service during 2008. This type of depreciation election should also be considered.

However, a common contrarian view of this topic should be mentioned. The discount rate applied to cash-flows in a DCF model is derived from publicly-traded securities. Analysts strive to adjust a subject company’s cash-flows to parallel cash-flows of public companies and public companies utilize economic depreciation in their financial statements. The character of a private company’s cash-flow/earnings will always differ from the character of public company’s cash-flow for a number of reasons.

Conclusion

It’s important to note that the scenarios above are simply examples and tax laws often change. The emphasis is that CPAs faced with similar situations should consider the actual income tax expense in cash-flow models. If the context of the valuation assignment is a fair market value standard, it is reasonable to assume a hypothetical buyer will choose depreciation methods that maximize their cash-flow.

Christopher W. David, CPA, ABV, ASA, is a Manager in the Denver office of RGL — Forensic Accountants & Consultants. He has extensive experience in the valuation of private companies for merger, acquisition, estate tax and gift tax matters.