**Components of Annual Net Cash Flows**

**Depreciation and taxes**

The computation of the after-tax cash flows requires a careful treatment of non-cash expense item such as depreciation. Depreciation is an allocation of cost of an asset. It involves an accounting entry and does not require any cash outflow; the cash outflow occurs when the assets are acquired.

Depreciation, calculated as per the income tax rule, is a deductible expense for computing taxes. In itself, it has no direct impact on cash flows, but it indirectly influences cash flow since it reduces the firm’s tax liability. Cash outflow for taxes saved is in fact an inflow of cash. The saving resulting from depreciation is called depreciation tax shield.

Taxes are paid on profits and calculated as follows:

**Taxes = Tax rate X ProfitTaxes = Tax rate X (Revenue – Expenses – Depreciation)Tax = T (REV – EXP – DEP)**

Where T is the corporate tax rate. Notice that the expression within brackets is taxable income, which is equal to earning before interest and taxes (EBIT), or net operating income (NOI). Thus,**Tax = T (EBIT)**

Net cash flow (NCF) can also be measured in the following way if we substitute above equations:

**NCF = REV – EXP) – T (REV – EXP – DEP)NCF = REV – EXP) – T (REV – EXP) + T (DEP)NCF = (REV – EXP) (1 – T) + T (DEP)NCF = EBDIT (1 – T) + T (DEP)**

It may be noted from the above computation that depreciation has provided a tax shield (DTS) equal to tax rate multiplied by the amount of depreciation:

**Depreciation tax shield = Tax rate X Depreciation**

We can obtain yet another definition of net cash flows by adjusting above net cash flow equation,

**NCF = REV – EXP – TAX – DEPNCF = EBIT – TAX + DEP**

And if we use the definition of tax as given in above equation, then:

**NAF = EBIT – T (EBIT) + DEP = EBIT (1 – T) + DEP**

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