I bumped into this issue while working out Elan’s PQ8 on Corporate Finance Capital Budgeting The equipment to replace has the following: • Sales: 355,000 • Cash Op Expenses: 170,000 • Depreciation: 180,000 The new equipment has the following: • Sales: 840,000 • Cash Op Expenses: 400,000 • Depreciation: 600,000 The company’s marginal tax rate is 40% The question of the exercise is: What is the change in after-tax operating cash flow? The answer given by Elan is to do the following: ∆CF = (∆Sales - ∆Expense)(1 - Tax) + ∆Depreciation * Tax ∆CF = (840000 - 355000 - (400000 - 170000))*0.6 + 420000*0.4 ∆CF = +321,000 But here is my problem, there is an alternative way of doing it, by looking at Before vs After: Before: • Sales: 355,000 • Cash Op Expenses: 170,000 • Depreciation: 180,000 => Operating Profit (Loss) = 5,000 => Net Income = 3,000 => CF = 183,000 (add back depreciation) After: • Sales: 840,000 • Cash Op Expenses: 400,000 • Depreciation: 600,000 => Operating Profit (Loss) = (160,000) => No tax is paid => Net Income = (160,000) => CF = 440,000 ∆CF = 440,000 - 183,000 = +257,000 So my questions are: is my Before vs After correct? Which is the correct answer, or stated differently, what would the CFAI want to see on exam day? Thanks for your advise.
CF = (S − C − D)(1 − T) + D = Annual after-tax operating cash flow, NOT Operating Profit
The distinction is important, in your example above, your assumption of no taxes paid is incorrect as a result
In the example I provided, the company is not liable for any tax payment because it operates at a loss (I don’t assume anything here), therefore there is no cash outflow to the tax administration, hence in that particular case, CF = (S - C - D) + D = S - C Or am I completely mistaken?
You pay taxes on EBT, not on operating cash flows.
And remember, you are looking at marginal cash flows relative to the specific investment decision (not the overall firm cash flows).
In the After scenario, I calculated EBT = -160,000 so no tax should be paid, isn’t it right?
You are calculating annual after-tax operating cash flow for the marginal impact of this specific replacement project. You are not calculating EBT for the entire company (e.g. if the remainder of the company is operating at a profit, you would still get the tax benefit of the losses on this particular project).
And separately, while the two concepts are obviously linked, the formula gives you cash flow, not earnings. Personaly i think it’s important to keep the distinction (you’ll note the text always refers to this as cash flow as well).
yes ro424 u r right eveningstar forgot to add tax saving on losses on new replaced project.i.e.(160000)*.4=64000 (inflow)