Whose Depreciation?
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- Category: Politics: Economics
- Date Submitted: 11/21/2011 08:43 PM
- Pages: 6
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Depreciation: Random Thoughts
Depreciation: Which definition do we use?
What is depreciation? On a general note, without going into too many technicalities, it is the charge for wear and tear. It is an annual reserve set aside by the firms to replace the capital at the end of its life. These two seemingly innocuous, similar definitions are different from each other. The first definition depends on the wear and tear of the machine without bothering anything about the cost of replacement. And cost of replacement depends on technological progress, competition and obsolescence. So, which is the one we use? It’s important because the one we use would determine the depreciation rate. Seems right. But, there is a catch in this too. How do we exactly know when would the next innovative machine come and replace the existing one? Answer is: We don’t know. That’s why we should use a rate that is more than the rate of wear and tear and that tries to factor in the next technological invention. Analysts’ guesswork begins much before the revenue, FCF forecast!!
Some people also define it as the rate at which the machinery value gets converted into a product’s value. E.g. - Purchase price of machine=10,00,000 INR. If we assume a flat rate of depreciation to be 20%, then at the end of 1st year, the machinery value would be 8,00,000 INR and the 2,00,000 INR(or 20% of the machine cost) must have been converted to the product’s value, making it a zero-sum game. Loss in the value of machine is equal to the gain in the value of product. Again right, but how do we know how much value would be transferred a priori? We don’t know again.
Philosophical Enquiry: Why and How?
What is the purpose of depreciation? In calculating free cash flows and even valuation multiples like EV/EBITDA, we exclude the effects of depreciation. Does it serve any purpose, besides earning firms a tax-shield? Marx and Mill both pointed out that the purpose of machine is not to lessen the burden of labour,...
Depreciation: Which definition do we use?
What is depreciation? On a general note, without going into too many technicalities, it is the charge for wear and tear. It is an annual reserve set aside by the firms to replace the capital at the end of its life. These two seemingly innocuous, similar definitions are different from each other. The first definition depends on the wear and tear of the machine without bothering anything about the cost of replacement. And cost of replacement depends on technological progress, competition and obsolescence. So, which is the one we use? It’s important because the one we use would determine the depreciation rate. Seems right. But, there is a catch in this too. How do we exactly know when would the next innovative machine come and replace the existing one? Answer is: We don’t know. That’s why we should use a rate that is more than the rate of wear and tear and that tries to factor in the next technological invention. Analysts’ guesswork begins much before the revenue, FCF forecast!!
Some people also define it as the rate at which the machinery value gets converted into a product’s value. E.g. - Purchase price of machine=10,00,000 INR. If we assume a flat rate of depreciation to be 20%, then at the end of 1st year, the machinery value would be 8,00,000 INR and the 2,00,000 INR(or 20% of the machine cost) must have been converted to the product’s value, making it a zero-sum game. Loss in the value of machine is equal to the gain in the value of product. Again right, but how do we know how much value would be transferred a priori? We don’t know again.
Philosophical Enquiry: Why and How?
What is the purpose of depreciation? In calculating free cash flows and even valuation multiples like EV/EBITDA, we exclude the effects of depreciation. Does it serve any purpose, besides earning firms a tax-shield? Marx and Mill both pointed out that the purpose of machine is not to lessen the burden of labour,...