Calculation of Annual Incremental After Tax Cash Flows First, realize different texts use different notation:

After-tax Net (Operating) Cash flows (NCF), After-tax Net Operating Cash flows (NOCF), After Tax Cash Flows (ATCF) (ACF), Incremental After Tax Cash Flows (ACF) ( ATCF),

But all of the above represent the same concept. Next, review some basic accounting: A simplified Income Statement = = Revenues Operating Expenses Depreciation Interest and Financing Expenses Earnings Before Taxes Taxes Earnings After Taxes (R) (O) (D) (F) (EBT) ($T) (EAT)

But in our cash flow calculation we do not include interest expenses or other financing costs so we can focus on operating Earnings Before Taxes (OEBT) rather than EBT. = = Revenues Operating Expenses Depreciation Operating Earnings Before Taxes Taxes Operating Earnings After Taxes (R) (O) (D) (OEBT) ($T) (EAT)

And if we add back non-cash charges such as Depreciation, we get; = = + = Revenues Operating Expenses Depreciation Operating Earnings Before Taxes Taxes Operating Earnings After Taxes Depreciation Net Cash Flows (after tax net cash flows) (R) (O) (D) (OEBT) ($TAX) (OEAT) (D) (NCF)

Or, simply, = = + = R O D OEBT $TAX OEAT D NCF

Now think about this = = So OEBT - $TAX = OEAT We get $TAX by multiplying OEBT by the tax rate (T) Or OEBT - (OEBT*T) = OEAT Or OEBT * (1-T) = OEAT So we end up with = * = + = R O D OEBT (1-T) OEAT D NCF OEBT $TAX OEAT

The above represents an easy calculation for Net (after tax) Cash Flow in any year.

And lay this calculation down on its side to get: R - O - D = OEBT * (1-T) = OEAT + D = NCF Note that this version does NOT reflect any changes in working capital investment. The textbook includes changes in net working capital in this annual calculation. Other texts include the changes in net working capital in the Net Investment (NINV) calculation and in the Terminal Cash Flows (or Salvage Value) calculation because there is usually an increase at the start of a project in WC investment and a recapture of WC investment when a project is shut down. These authors have chosen to include the changes in the annual cash flows. Now our focus is on Incremental After Tax Cash Flows and the above equation gives us single year cash flows - they are not incremental. To calculate Incremental NCFs we must identify our two possible investment choices. In the simple case, we either accept the project or we reject the project.

If we reject, nothing changes but we still have a set of possible CFs generated by current operations. Let (wo) represent the values without the project. Rwo Owo Dwo OEBTwo $TAXwo OEATwo Dwo NCFwo

= = + =

If we accept, there may be changes in any of the components of the operating cash flow calculation so we have another possible set of CFs generated by current operations plus the new project. Let (w) represent the values with the project. Rw Ow Dw OEBTw $TAXw OEATw Dw NCFw

= = + =

To get the Incremental Net cash Flows, we subtract the calculation without the project from the calculation with the project = = + = [ Rw - Rwo [ Ow - Owo [ Dw - Dwo [ OEBTw - OEBTwo [ $TAXw - $TAXwo [ OEATw - OEATwo [ Dw - Dwo [ NCFw - NCFwo R O D OEBT $TAX OEAT D NCF ] ] ] ] ] ] ] ]

= * = + =

= * = + = or = * = + =

R O D OEBT (1-T) OEAT D NCF

Incremental Revenues Incremental Operating Expenses Incremental Depreciation Incremental Operating Earnings Before Tax tax rate (to get incremental after tax operating earnings) Incremental Operating Earnings After Tax Incremental Depreciation Incremental After Tax Cash Flows

(remember, incremental working capital investment, NWC, is included in the calculation elsewhere)

Calculation of Annual Incremental After Tax Cash Flows The calculation of incremental after tax cash flows for each of the years of the project under consideration is one of the most important steps in the capital budgeting decision process. The hardest part of this stage of the capital budgeting process is the identification of future incremental cash flows that are associated with the investment project under consideration. Once all of these annual incremental after tax cash flows are identified, it is a relatively simple matter to calculate the incremental cashflows for any particular year. This step of the capital budgeting process involves the following steps: 1. Identify incremental revenues. When undertaking a new project, there may be an impact on the level of annual revenues for the company. Often, a replacement project does not have any impact on the productive capacity of the firm or the level of sales of the firm. New projects that change the level of productive capacity of the firm, however, will have an incremental impact on the firm's revenue. For example, an increase in productive capacity in the form of a new factory or new production line, will increase revenues for the company. In this case, the increased revenues must be included into the annual incremental cash flow calculation. Alternatively, there may be projects under consideration that involve a decrease in the firm's productive capacity and output. For example, a project may be under evaluation that will close an existing product line or shut down an existing factory. In this case, the incremental revenues associated with the acceptance of the project will be negative.

2. Identify changes in operating cash flows The second major category of items to be included in the incremental cash flow calculation is changes in cash operating expenses. For purposes of the calculation, all cash operating expenses can be included under this general category. These operating expenses would include labor expenses, materials expenses, and allocated indirect or overhead expenses. Operating expenses may be either increases or decreases as a result of an investment in the new project. If the project is a replacement project, acceptance of the new project often results in a decrease of operating expenses. This is because many types of replacement decisions often reflect the purchase of new, more efficient, equipment that is replacing older, less efficient equipment. The change from older equipment to newer equipment often reduces labor expenses, reduces inventory wastage, or results in a savings associated with energy costs. New projects that expand productive capacity, however, often increase operating expenses. The best example of this type of a project might be a project to build a new factory. In these cases acceptance of the new projects will increase various operating expenses such as labor expenses, materials expenses, and other operating related cash expenditures. Regardless of whether or not the change in operating expenses is an increase or a decrease, the incremental impact must be included in the cash flow calculation. Since we do not include financing costs in our calculation of the operating cash flows, be sure that any incremental interest or other financing expenses are not included in this calculation.

3. Identify changes in non-cash expenses The second types of expenses included in our incremental after tax cash flow calculation are non-cash expenses. The three major categories of non-cash expenses include depreciation, depletion, and amortization. While all three of these types of non cash expenses may be included in project, the most common of the three is depreciation. Replacement decisions usually involve an increase in depreciation expenses that are associated with the new project. This is because the replacement decision typically replaces an older piece equipment or machinery that has been depreciated over its life with a newer piece of equipment that has yet to be depreciated. The total installed costs The total installed costs of the project provides the information for calculating the depreciable basis of the equipment associated with the project under consideration. Once the depreciable basis is arrived at, depreciation schedules for the equipment included in the project are calculated and the annual depreciation expense amounts are included in the annual cash flow calculation. If the project under consideration expands the productive capacity of the firm, the depreciation associated with the new project will be the incremental depreciation.

4. Calculation of the incremental earnings before taxes Once the incremental revenues, incremental cash operating expenses, and incremental non cash depreciation expenses have been identified, the information can be used to calculate the incremental earnings before tax on an annual basis for each year of the project forecast. The calculation is as follows: When calculating the incremental earnings before tax, care should be taken to make sure that the incremental changes, and the signs of the incremental changes, were properly reflected in the calculation. After calculating the Incremental operating earnings before taxes, subtract the amount of taxes to be paid on this amount. The easiest way to perform this calculation is to multiply the Incremental operating earnings before tax amount by ( 1- tax rate ) to state on after tax basis. Finally, add the incremental depreciation back to the after tax operating earnings to et the net cash flows for each year. = * = + = Start with incremental revenues Incremental expenses Incremental non-cash charges Incremental operating earnings before taxes ( 1 - tax rate ) Incremental operating earnings after taxes Incremental non-cash charges Net (incremental) After Tax Cash Flows