Valuation: Depreciation

Depreciation

For the uninitiated, Depreciation is a term used in accounting, economics and finance to spread the cost of an asset over the span of several years. That is depreciation is method of attributing the historical or purchase cost of an asset across its useful life. The rate of depreciation (usually a % of the asset value) differs by asset class and depending on whether it is for accounting purpose or for tax. i.e. there would be a tax depreciation and a different Book(accounting) depreciation.

Depreciation is a non cash expense. It doesn’t affect the cashflow and hence the DCF directly. However, the tax depreciation is deducted from the taxable profits so it affects the tax directly and hence the DCF.

The typical methods of depreciation used for tax or accounting purposes are as follows

1. Straight line method (SLM) – where the asset is depreciated in equal installments over the life of the asset. i.e depreciation for the year = (cost of asset – salvage value)/(life of asset). For eg. If an equipment is bought for USD 100 and depreciated at 10% to USD 10 Residual value under SLM. Depreciation for the year = 10% *(100-90
   ) = 9 USD
2. Declining balance method (Written down value WDV) – where the depreciation for the year is equal to a fixed percentage of the book value of the asset at the start of the year. For eg for the above example, the depreciation for the first year @15% rate of WDV = 15%*100 = 15. The Net book value at end of year 1 is 100-15=85. WDV for year 2 = 15% *NBV =15%*85 =12.75.
3. Unit of production – very commonly used method where the depreciation is equally divided over the unit of production. In case of mining, where the above depreciation methods are not clear, the Unit of production provides a fair estimate of the depreciation.

Depreciation for the year = (cost of fixed asset – residual value)*(annual production/total production over life)

Practically for calculation purposes for mining, Opening book value*(annual ROM production)/(Mineable Reserves) can be used for the estimating the annual depreciation.

Please note, the aim is to match the tax depreciation as per the tax laws of the country as applicable to the mine under evaluation. A study of tax depreciation should be used for determining this. Certain countries provide for “capital allowances” for the capital expenditure instead of depreciation. For the purposes of calculation, the nomenclature is immaterial. Capital allowances can be considered same as depreciation.

Alternatively, depreciation for the last financial period as percentage of the opening book value can be used for simplicity sake.

Opening Book Value + Capital expenditure - Depreciation for the year= closing book value for each period.

Gross fixed assets - accumulated depreciation = Net Fixed Assets (Closing book value)