Return

For example, look at a project with a depreciation life of 3 years according to the I.R.S. using the half-year convention. The following rates apply

Year 1 33.33%
Year 2 44.45%
Year 3 14.81%
Year 4 7.41%

The project costs 100,000 and is expected to generate operating income of $50,000 per year.The firm is in a 35% tax bracket and wants to estimate the cash flows:

Year
1
2
3
4
Operating Income
$50,000
$50,000
$50,000
$50,000
Less Depreciation
-33,333
-44,450
-14,810
-7,410
Profit Before Tax
16,667
5,550
35,190
42,590
Less Tax
-5,833
-1,943
-12,317
-14,907
Profit After Tax
10,834
3,607
22,873
27,683
Plus Depreciation
33,333
44,450
14,810
7,410
Cash Flow
$44,167
$48,057
$37,683
$35,093

An alternative is to multiply the operating income by (1 - tax rate) and add the depreciation multiplied by the tax rate. Since the purpose of depreciation is to save taxes, this captures the tax savings provided by depreciation and is a simpler means to estimate cash flows:

Year
1
2
3
4
Operating Income
$50,000
$50,000
$50,000
$50,000
times (1-.35) =
$32,500
$32,500
$32,500
$32,500
Depreciation
33,333
44,450
14,810
7,410
times .35 =
11,667
15,557
5,183
2,593
Cash Flow
$44,167
$48,057
$37,683
$35,093