Depreciation Tax Shield
The cash a business keeps because depreciation is deductible: the charge multiplied by the marginal tax rate. It is the reason a non-cash accounting entry still has a cash value, and it is why a DCF deducts D&A to reach taxed EBIT and then adds the charge back rather than ignoring it at both ends.
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Why Depreciation Tax Shield matters in interviews
The tax shield is the answer to the question candidates get wrong most often: if depreciation is not cash, why does it matter to a valuation? It matters because the deduction is real even where the expense is not, and the difference is what turns an accounting entry into cash the business keeps.
How it works in practice
The shield is the depreciation charge multiplied by the marginal tax rate. A £1m charge at a 25% rate saves £250k of tax, so the business ends the year with £250k more cash than it would have had if the same asset had not been depreciable. That is the entire mechanism, and it is why the classic three-statement question about a $10 depreciation charge ends with cash up $2.50 rather than unchanged.
In a DCF the shield is captured without ever being computed separately. Unlevered free cash flow starts from EBIT, which is after depreciation, taxes that figure, and then adds the depreciation back. Deducting it before tax is what lets the deduction reduce the tax bill; adding it back after tax is what removes the non-cash part. Skip the first step and you have thrown the shield away, which overstates the tax charge and undervalues the business.
The shield is why tax depreciation and book depreciation are worth distinguishing. Many regimes allow accelerated allowances, so the deduction taken against taxable profit in the early years exceeds the charge in the accounts. The gap creates a deferred tax liability and pulls cash forward, which is exactly the point of the allowance as a policy. A model that uses the book charge for both is approximating, and in a capital-intensive deal the approximation is worth real money.
In an LBO the shield is one of the three sources of return alongside deleveraging and multiple expansion, and it is the one that survives when the others do not. It also competes with the interest shield: a company with large depreciation deductions and limited taxable profit may not be able to use all of its interest deduction, which is where interest limitation rules start to bite.
What candidates get wrong
- Saying the tax shield is worth the full depreciation charge. It is worth the charge times the tax rate, and a company with no taxable profit gets nothing from it this year at all.
- Using the statutory rate when the company plainly does not pay it. The marginal rate on the next pound of profit is the right one, and a group with losses carried forward, patent box relief or a heavy foreign mix is often a long way from the headline number.
- Adding depreciation back before tax in a free cash flow build. It removes the deduction along with the non-cash charge, which is the single most common arithmetic error in a hand-built DCF.
- Forgetting that amortisation of goodwill is not deductible in most regimes, so it carries no shield even though it sits in the same line as charges that do.
Depreciation Tax Shield: frequently asked questions
What is the depreciation tax shield and how is it calculated?
It is the tax saved because depreciation is a deductible expense, calculated as the depreciation charge multiplied by the marginal tax rate. A £4m charge at a 25% rate is a £1m shield. No cash moves on account of the charge itself, but £1m less cash leaves the business as tax, which is why a non-cash entry still has a cash value and why free cash flow ends up higher than it would be without it.
Why is depreciation subtracted and then added back in a DCF?
Because the two steps do different jobs. Subtracting it before tax lets the deduction reduce the tax charge, which is the shield. Adding it back after tax removes the part of the expense that never cost any cash. Doing only the second step overstates tax and undervalues the company; doing only the first understates cash flow. The order is what captures the shield without double counting the expense.
Does the tax shield still apply if the company is loss-making?
Not in the current year. A deduction only saves tax where there is taxable profit to deduct it from. The benefit is usually deferred rather than lost, because losses can be carried forward in most regimes and the shield lands in the first year the company is profitable. In a valuation this shows up as a deferred tax asset and as a forecast with no tax charge for several years, then a normal one.
Practise it
The schedule a real model uses: one layer per capex vintage, each depreciating over its own useful life, with the charge as the column total. Switch the life, switch to an accelerated method, or type over a capex year and watch the stack move.
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