How Does $10 of Depreciation Affect Free Cash Flow?

The trap is thinking depreciation moves cash directly — it doesn't. Depreciation is a non-cash expense, so when you build the cash flow statement, you add it back to net income in full because it was deducted on the income statement but no cash left the company. The net effect on cash is therefore zero EXCEPT for taxes: by lowering pre-tax income by $10, depreciation lowers the cash tax bill by $10 × tax rate. That tax saving is the only real cash impact. This is the depreciation tax shield, and it's why a higher depreciation expense, counterintuitively, increases free cash flow.

Income Statement: $10 more depreciation lowers pre-tax income by $10; at a 25% rate, net income falls by $7.50. Cash Flow Statement: start with net income down $7.50, then add back the full $10 of (non-cash) depreciation — net change in cash flow from operations = -$7.50 + $10 = +$2.50. Balance Sheet: cash is up $2.50; PP&E (or accumulated depreciation as a contra-account) is down $10; retained earnings is down $7.50 (the lower net income). Check it balances: assets change = +$2.50 (cash) - $10 (PP&E) = -$7.50; equity change = -$7.50. It balances.

Free cash flow (specifically unlevered FCF) is typically built as EBIT × (1 - tax) + D&A - CapEx - change in working capital. When you add $10 of depreciation: EBIT falls by $10, so EBIT × (1-25%) falls by $7.50; but you then add back the full $10 of D&A; net = +$2.50. Both methods — three-statement and FCF-formula — give the same answer, which is a great thing to point out in an interview because it shows you understand the mechanics from two angles.

'What if the tax rate is 0%?' → FCF impact is $0; with no taxes there's no shield, and a non-cash expense has zero cash effect. 'What if it's $10 of amortization of an intangible?' → same logic and same answer, as long as it's tax-deductible (note: certain acquisition-related intangible amortization may not be tax-deductible, in which case there's NO shield and the answer is $0). 'What if it's CapEx instead of depreciation?' → $10 of CapEx reduces FCF by the full $10 (it's a real cash outflow), with no tax effect in the period. Knowing the difference between depreciation (non-cash, tax shield) and CapEx (cash, no immediate tax effect) is the deeper point being tested.