How do taxes correctly enter capital budgeting cash flow analysis?

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AcadiFi · Accepted Answer

Capital budgeting requires after-tax operating cash flows and proper treatment of depreciation, working capital, and terminal values: Operating cash flow formula: OCF = (Revenue - Operating costs)*(1-T) + Depreciation*T. The depreciation tax shield equals Depreciation*T because depreciation is not a cash outflow but reduces taxable income. For Mariposa's machine: $5M cost, 5-year MACRS (rates 20%, 32%, 19.2%, 11.52%, 11.52%, 5.76%), generates annual revenue $2.2M, operating costs $0.8M, tax rate 25%. Year 1 depreciation = 5M * 20% = $1M, tax shield = 1M * 25% = $250K. OCF_1 = (2.2 - 0.8)*0.75 + 0.25*1.0 = 1.05 + 0.25 = $1.30M. Initial investment (year 0): equipment cost ($5M) + installation + working capital increase - any salvage from replaced equipment. Suppose $200K installation and $150K working capital: initial outlay = 5.2 + 0.15 = $5.35M. Terminal year: (1) salvage value minus tax on gain—if book value at year 5 is $288K (5.76% remaining) and salvage is $800K, tax on gain = (800-288)*25% = $128K, after-tax salvage = 800 - 128 = $672K; (2) working capital recovery = $150K. ```mermaid flowchart TB R[Revenue] --> O[Operating
income] C[Costs] --> O O --> T[Taxes
applied] D[Depreciation
shield] --> CF[After-tax
cash flow] T --> CF ``` Key adjustments: (1) use after-tax cost of debt in WACC = Kd*(1-T); (2) sunk costs and allocated overhead are irrelevant—only incremental cash flows; (3) opportunity costs (alternative uses of resources) should be included; (4) bonus depreciation (current 60% under TCJA phase-down) front-loads tax shields, boosting NPV. Mariposa's NPV at 10% WACC = -5.35 + PV(OCF) + PV(terminal) should be positive to accept.

How do taxes correctly enter capital budgeting cash flow analysis?

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