Negative Cash Flow and Tax in Corp Finance

CFA Level II Corporate Finance
#1

This is directed at S2000Magician coz I’m not getting any response from Kaplan.

There was a question in Exam 3 in the Schweser Vol1 book where there was a negative after tax cash flow in one of the years for a project. The solution given added back the tax portion whereas I would’ve thought tax would be NIL if there was a loss. So if tax is added back (eg. if negative CF was -$100K add tax of $40K back so net -$60K), this implies that the tax office will refund the tax portion for losses the client makes. What is correct?

I can understand if maybe we assume that the tax losses can be carried forward and used to offset future income but then this would need to be discounted in the future years which will complicate the whole solution (especially in an exam situation).

I could only find one other thread on this a few years ago but need S2000’s ‘magic’.

#2

I didn’t fully understand your explanation, but here what I think about tax losses for Corporate Finance purposes (CFA exam of course)

You have:

EBITDA = 200,

Depreciation = (300)

Interest = 0

EBT = -100

Tax = 30%

Net Income = -70

You have to treat the 30% * -100 as if it were an inflow, so you add 30 back to your Net Income calculation, hence to your CF calculation. I am not sure in real life it does work like that, because tax losses are carried forward, or off-set with other corporate tax deductions, etc…

#3

Yep - what Sharky said - you just basically treat the “negative” tax as a cash inflow.

Seems a little weird but I have come across that situation in a number of prep providors mocks/sample questions and they all deal with it that way.

#4

The logic is that the company’s other activities are profitable so the tax loss can be used in the same period to lower taxes. No need for tax loss carryforward.

#5

Agree and that’s how we should treat it, but just FYI in real life it does not work that easy.

No matter that you have enough income to offset, tax rules normally impose limits on the max. amount to offset, etc. But yes, for the exam just treat it as if it’s an inflow in the year that was generated.

#6

In the real life depends on national tax regulations and international tax agreements. For example in Bulgaria we can offset taxes with tax losses generated in Cyrpus or Romania.

#7

Is the income that year negative, or only the cash flow?

#8

The argument is as follows :

  • If you are considering this as a stand alone project or a company, you can treat it as zero ( no taxes on negative OI) but then you have to consider NOLs
  • If you are considering it as a project inside the company, you will consider that the company will have enough income in its other business to claim the tax benefit immediately and hence use 40% (tax rate) of that negative operating income in the same year
#9

Thanks guys, that was the confirmation I was looking for. There’s no example in the CFA material where a project has a year of negative net income (thanks for the pick up S2000).

I just found it weird why the Schweser solution would “add back” tax in that year of the negative net income (eg.

-$100K cash flow and then instead of tax being NIL, it is say +$40K @40% thus after tax income is -$60K before you add back the Depreciation to come to the after tax cash flow).

But if you guys saw it treated this way in other mocks, then we’ll go with this approach on exam day.

#10

I think in the exam, we will have to add the tax on negative OI because NOLs are not part of the curriculum