Depreciation in Corporate Models

Depreciation Expense in a corporate model can be one of the trickiest issues from a mechanical and theoretical perspective. When new assets built have a different growth profile than the historic existing assets, it is easy to make errors in the modelling of depreciation expense. This page includes discussion and exercises on how to efficiently and accurately model depreciation expense in different types of models. The first issue addressed is computing depreciation on future capital expenditures when the depreciation rate is not the same over the lifetime of assets. This problem sometimes results in one of those diagonal matricies that you may have seen. I think it is much better to solve this depreciation problem with a user defined function. For corporate models, a second problem is when the depreciation rate is not constant for new assets, you should account for the vinatge depreciaton of each capital expenditure. You can use the depreciation on net plant, but this does not work if growth rates change. If you are more price, one of the most challenging aspects of corporate modelling is the representing retirements of existing assets because this requires gleaning historic information from financials.

A second problem with depreciation is the theory of depreciation as it applies to companies with lumpy assets. If assets age, the return on equity appears to be much higher after the asset ages. The return on equity is highest just before the next asset is added. The same problem occurs in terms of the P/E ratio. Just after a lumpy asset is completed, the income is low and the future cash flow is high. This implies a high P/E ratio. When the asset is old, the value goes down because of the pending capital expenditure. In addition the income is high. This makes the P/E low. Economic depreciation can resolve this issue. I am not suggesting to re-cast financial statements with economic depreciation but I do think that you should think about the theory. The second lesson set therefore works through economic depreciation.

wcomputing depreciation expense on the basis of gross assets without considering retirements. The correct depreciation should account for retirements on both new assets and existing assets.

Videos Associated with Lesson Set 2: Modelling Retirements for Existing Plant

 

This file includes functions to make a diagonal matrix that includes the effect of retirements and different types of depreciation.

Depreciation Lesson Set 3: Economic Depreciation Theory

This lesson set begins by working through a file with a bunch of mistakes as a case study. One of the big mistakes is to use gross plant in computing depreciation expense on the basis of gross assets without considering retirements. The correct depreciation should account for retirements on both new assets and existing assets.

Subject Excel Exercise File Video Chapter Reference Page Reference
Depreciation Errors from applying gross rates and net rates Depreciation Exercise 1: Errors in Methods 21
Creating Depreciation Vintage Matrix without a function Depreciation Exercise 2: Vintage Matrix https://www.youtube.com/watch?v=-gBle2ERzGY 25
Creating Depreciation Vintage Matrix with Function Depreciation Exercise 3: Matrix Matrix with Function
Creating Historic Growth Function Depreciation Exercise 4: Historic Growth Function
Creating Base Retirement Function Depreciation Exercise 5: Base Retirement Function
Implementing Depreciation Functions in Corporate Models Depreciation Exercise 6: Depreciation Functions in Corporate Models
Implementing Depreciation in Functions in Project Finance Depreciation Exercise 7: Depreciation Functions in Project Models
Projecting Deferred Taxes Depreciation Exercise 8: Deferred Taxes
Projecting Deferred Taxes with Changing Growth Depreciation Exercise 9: Deferred Taxes and Changing Growth
Comparison of Methods Depreciation Exercise 10: Comprehensive Exrcise https://www.youtube.com/watch?v=secSWQYuTiI
Computing Depreciation with Different Methods Depreciation Exercise 10: Comprehensive Exrcise https://www.youtube.com/watch?v=4gPt_D5N6KY
Depreciation Expense Calculations https://www.youtube.com/watch?v=u9O9XanLQhY
Theoretical Depreciation Expenses
Example of Deprecaition Expense Errors
Depreciation Function with Changing Rate Corporate and Project Model https://www.youtube.com/watch?v=cZXwgLHqbTg
Existing Depreciation and Retirments Kitty Hawk Model https://www.youtube.com/watch?v=tyLTTmZWljY
Debt and Depreciation in Corporate Model Kalitta Corporate Model https://www.youtube.com/watch?v=tyLTTmZWljY
Existing Depreciation with Solver Existing Depreciation https://www.youtube.com/watch?v=XmkTCI8TkGw
Recasting Existing Depreciation with Economic Depreciation Economic Depreciation with Function
Economic Depreciation on New Assets Economic Depreciation on New Assets
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