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 vintage depreciation 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.

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.

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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