Depreciation Goes Up by $10: How Every Line of the 3 Statements Changes

"Walk me through what happens when depreciation increases by $10." This is one of the most common technical questions in investment banking interviews. It looks simple, but interviewers use it to check whether you actually understand how the three statements connect or just memorized a script.

The short version (at a 25% tax rate): net income falls by $7.50, cash rises by $2.50, PP&E falls by $10, and the balance sheet balances because assets and equity both drop by $7.50.

Below, we walk through every line, explain why each one moves, and cover the follow-up questions that trip people up.

The Assumptions You Should State Out Loud

Before you answer, quickly state your assumptions. It shows structure and protects you if the interviewer had a different setup in mind.

• Tax rate of 25%. Some interviewers use 40%. Use whatever they give you, or pick one and say it.
• The depreciation is both book and tax depreciation. It reduces taxable income on the income statement and the taxes you actually pay.
• Nothing else changes. No new capex, no change in revenue, no change in debt.

That's it. Now let's go statement by statement.

Step 1: The Income Statement

Depreciation is an expense, so it reduces profit. Here's the line-by-line effect:

Why EBITDA doesn't move

EBITDA is calculated before depreciation, so by definition it's untouched. This is a great detail to mention because it shows you know why bankers like EBITDA as a proxy for operating cash flow.

Why taxes fall

Pre-tax income dropped by $10, so the company owes 25% less on that $10. That's $2.50 in tax savings. This is the depreciation tax shield, and it's the whole reason cash ends up going up.

Step 2: The Cash Flow Statement

Start with net income, then adjust for non-cash items.

Why you add back the full $10

Depreciation reduced net income, but no cash left the building when you recorded it. The cash was spent years ago when the asset was bought (that showed up in capex). So you add the full $10 back.

The only real cash effect is the lower tax bill: $10 of extra expense times 25% equals $2.50 more cash.

Why investing is unchanged

A common mistake is thinking higher depreciation means higher capex. It doesn't. We're only changing how fast an existing asset is expensed. No new money is spent on equipment.

Step 3: The Balance Sheet

Now make sure it balances.

Assets

• Cash: +$2.50 (from the cash flow statement)
• PP&E (net): -$10 (accumulated depreciation increased by $10)
• Total assets: -$7.50

Liabilities

• No change. We assumed the tax savings were real cash savings, so nothing new is owed or deferred.

Shareholders' equity

• Retained earnings: -$7.50 (net income flows straight in)
• Total equity: -$7.50

The check

Assets: -$7.50. Liabilities + equity: -$7.50. Balanced.

The 30-Second Interview Answer

Here's how you'd actually say it out loud:

"On the income statement, operating income falls by $10. Assuming a 25% tax rate, net income falls by $7.50. On the cash flow statement, net income is down $7.50, but we add back the $10 of non-cash depreciation, so cash from operations and total cash are up $2.50. On the balance sheet, cash is up $2.50 and PP&E is down $10, so total assets fall by $7.50. On the other side, retained earnings fall by $7.50 because of lower net income, so the balance sheet balances."

Practice this until it flows. Interviewers care about the order and logic as much as the numbers.

Quick Reference: What If the Tax Rate Is 40%?

Same logic, different numbers. Here's the 40% version so you're ready either way:

The shortcut: cash goes up by $10 × tax rate. Net income goes down by $10 × (1 - tax rate). PP&E always goes down by the full $10.

Follow-Up Questions You Should Expect

Strong candidates get pushed further. Here are the most likely curveballs.

"Wait, an expense went up and cash went up? How?"

Because depreciation itself isn't a cash expense, but it is tax-deductible. You get a real cash benefit (lower taxes) from a non-cash charge. That's the tax shield.

"What if depreciation is included in COGS?"

Many manufacturers bury depreciation in COGS. In that case, gross profit also falls by $10, and so does operating income. Everything below EBIT plays out exactly the same. EBITDA still doesn't change, since you'd add the depreciation back when calculating it.

"What if the extra depreciation is only for tax purposes, not book?"

This is the advanced version. Companies often use faster depreciation for taxes than for their reported financials. If only tax depreciation rises by $10:

• Income statement: reported net income doesn't change, since book depreciation is unchanged. Total tax expense on the income statement also stays the same, but the split shifts: current (cash) taxes fall by $2.50 and deferred tax expense rises by $2.50.
• Cash flow statement: net income is unchanged, but you add back the $2.50 increase in deferred taxes. Cash is up $2.50.
• Balance sheet: cash +$2.50 on the asset side, deferred tax liability +$2.50 on the liability side. Balanced.

The logic: you paid less tax today, but you'll pay it back later when book depreciation catches up. That future obligation is the deferred tax liability.

"Does this make the company more valuable?"

In a DCF, unlevered free cash flow includes the tax shield, so faster depreciation pulls tax savings forward and increases present value slightly. But total depreciation over an asset's life is capped at what you paid for it. You're shifting timing, not creating money out of nothing.

Mistakes That Cost Candidates Points

• Saying cash falls by $10. Depreciation is non-cash. Cash goes up.
• Forgetting PP&E. Without the -$10 on PP&E, your balance sheet won't balance.
• Adding back $7.50 instead of $10. You add back the full depreciation, not the after-tax amount.
• Touching capex. No new assets are purchased in this scenario.
• Saying EBITDA falls. It doesn't. That's the point of EBITDA.

The Takeaway

The depreciation question is really a test of one idea: non-cash expenses lower profit, but they can raise cash through taxes. Once you understand that, the numbers fall into place on all three statements.

Nail the base case, know the 25% and 40% versions cold, and be ready to talk through the COGS and deferred tax variations. Then practice saying it out loud until it takes you under 30 seconds.