Basically, the analyst calculates the after tax earnings of the investment or project, and then adds back the depreciation charge. Depreciation s counted as a cost that acts as a shield to diminish the tax effect. Then the depreciation charge is added back to after-tax earnings because it is a non-cash expense. Depreciation represents the declining economic value of an asset, but is not an actual cash outflow.
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Let’s say a financial analyst must calculate the cash flow after tax of a corporate project with operating income of $20 million dollars, a depreciation charge of $3 million dollars, and a tax rate of 40%.
First, the financial analyst would subtract the depreciation charge of $3 million dollars from the operating income of $20 million dollars. This would result in a profit before tax of $17 million dollars.
Then the financial analyst would calculate the effects of the tax charge by multiplying $17 million dollars by 60%, or one minus the tax rate, resulting in an after-tax income of $10.2 million dollars.
And finally, the analyst adds back the depreciation charge of $3 million dollars. While the depreciation charge has a real effect on taxes, and is thus a relevant figure, it is not an actual cash outflow, so it must be added back to after-tax income. So the cash flow after tax is $13.2 million dollars.
Operating Income $20 Less Depreciation 3 Profit Before Tax 17 Less Tax Charge 6.8 Income After Tax 10.2 Plus Depreciation 3 Cash Flow After Tax $13.2
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Higgins, Robert C., “Analysis for Financial Management”, McGraw-Hill Irwin, New York, NY, 2007.