EME 460
Geo-Resources Evaluation and Investment Analysis

After Tax Cash Flow

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After revenue and costs are determined, taxable income and income tax need to be calculated. Tax calculations can be very complicated, but here we just address the basics. Usually, in a specified time period, total costs deducted from total revenue gives the taxable income. Before-Tax and After-Tax Cash Flow can be calculated as:

Revenue
− Operating Costs
− Capital Cost
————————————————
Before-Tax Cash Flow (BTCF)
− Income Tax
————————————————
After-Tax Cash Flow (ATCF)

Operating and Capital Costs deducted from Revenue gives the Before-Tax Cash Flow. And After-Tax Cash Flow equals Before-Tax Cash Flow minus Income Tax.

Example 7-1:

Assume a project that has the estimated gross revenue of $28,000 dollars, operating cost of $12,000, and capital cost of $10,000 next year with the income tax of $1,500. Then, next year After-Tax Cash flow can be calculated as:

After-Tax Cash flow=$28,000−$12,000−$10,000−$1,500=$4,500

From a tax view point, there are two types of investments. According to US tax law, for the purpose of tax calculations, an investor is allowed to recover some specified types of investments, meaning that the investor can take some amounts of money from the generated revenue as tax deductions. Types of property that may be recovered over their useful lifetime are including (but not limited to) building, machinery, equipment, and trucks. Simply, most of the property types that lose their value over the time (have zero or low salvage value) may be allowed to be recovered. On the other side, there are investments that can’t be deducted from income for tax purposes. Investing in a bank account or buying land are the examples of this type.

Example 7-2:

Assume an investor deposits $100,000 in a bank account for 10 years with annual interest of 16% and will take the $100,000 in the end of 10th year. Calculate Before-Tax Cash Flow and After-Tax Cash Flow in this investment considering the income tax of 25%.

The annual income will be $100,000*0.16=$16,000 .

Since tax deduction is not allowed for investments such as bank account and bond, the annual revenue is fully taxable.

Income tax per year=$16,000*0.25=$4,000.
Year 0 1 2 3    ...    9 10
Revenue $16,000 $16,000 $16,000    ...    $16,000 $16,000
- Cost -$100,000
+ Salvage $100,000
BTCF -$100,000 $16,000 $16,000 $16,000    ...    $16,000 $116,000

In order to determine After-Tax Cash Flow, we need to determine the taxable income and deduct the tax from Before-Tax Cash Flow.

Year 0 1 2 3    ...    9 10
Revenue $16,000 $16,000 $16,000    ...    $16,000 $16,000
Taxable Income $16,000 $16,000 $16,000    ...    $16,000 $16,000
- Income Tax of 25% -$4,000 -$4,000 -$4,000    ...    -$4,000 -$4,000
Net Income $12,000 $12,000 $12,000    ...    $12,000 $12,000
- Cost -$100,000
+ Salvage $100,000
ATCF -$100,000 $12,000 $12,000 $12,000    ...    $12,000 $112,000

By trial and error, the ROR=12% is calculated for this After-Tax Cash Flow.

Example 7-3:

Now, assume the investor pays 100,000 dollars for a machine at time zero, and the machine can start producing goods and generating annual revenue of $38,000 with operating cost of $12,000 from first to 10th year, and the salvage value will be zero with income tax of 25%.

The Before-Tax Cash Flow here can be determined as:

Year 0 1 2 3    ...    9 10
Revenue $38,000 $38,000 $38,000    ...    $38,000 $38,000
- Operating cost -$12,000 -$12,000 -$12,000    ...    -$12,000 -$12,000
- Capital cost -$100,000
BTCF -$100,000 $26,000 $26,000 $26,000    ...    $26,000 $26,000

By trial and error, ROR=22.6% for Before-Tax Cash Flow.

In this hypothetical case, the investor is allowed by tax law to recover the out of pocket cash “capital cost” and gradually deduct it from taxable income. One way to calculate the taxable income for each year is to distribute the capital cost of $100,000 equally over the allowable depreciation life time of 10 years. And After-Tax Cash Flow will be determined as:

Year 0 1 2 3    ...    9 10
Revenue $38,000 $38,000 $38,000    ...    $38,000 $38,000
- Operating cost -$12,000 -$12,000 -$12,000    ...    -$12,000 -$12,000
- non-cash capital cost deduction -$10,000 -$10,000 -$10,000    ...    -$10,000 -$10,000
Taxable income $16,000 $16,000 $16,000    ...    $16,000 $16,000
- Income tax $4,000 $4,000 $4,000    ...    $4,000 $4,000
Net Income $12,000 $12,000 $12,000    ...    $12,000 $12,000
+ non-cash capital cost $10,000 $10,000 $10,000    ...    $10,000 $10,000
- Capital cost -$100,000
ATCF -$100,000 $22,000 $22,000 $22,000    ...    $22,000 $22,000

This way, the taxable income for each year would be 16,000 dollars, which gives the tax of 16,000*0.25=4,000 dollars . Note that, in reality, no annual cash is transferred and the annual sum of $10,000 (non-cash capital cost deduction) is applied just for the purpose of tax calculations. This annual sum is called non-cash capital cost to adjust and recover the the capital cost of $100,000 at time zero. And when tax is calculated, $10,000 has to be returned to cash flow to give the After-Tax Cash Flow.

ROR for After-Tax Cash Flow is 17.7%.

Applying tax deductions to recover the investment causes lower taxable incomes and consequently lower taxes and can only be used for specified types of properties. Investments that are allowed to be recovered by tax law are divided into two categories.

1)Investments that can be expensed: These investments are allowed to be deducted from revenue in full amount in the year of occurrence for tax calculation.

2) Capital costs: These investments are allowed to be deducted gradually (cost needs to be distributed over more than one year) from the revenue for tax calculation.
Depreciation, depletion, and amortization are methods that can be utilized to calculate the distribution of capital costs deductions over the time.

Acquisition costs and lease bonus costs paid for mineral rights for natural resources such as oil and gas are examples of investment property costs that may be recovered by depletion. Numerous other business costs such as the cost of acquiring a business lease, research and development costs such as expenses, trademark expenses, and pollution control equipment costs may be recovered by amortization. Depreciation, depletion, and amortization all achieve essentially the same thing—recovery of the cost or other basis of investments in before-tax dollars through allowable tax deductions over a specified period of time or over the useful life of the investment. If depreciable property is sold, all or a portion of any extra depreciation claimed in prior years may have to be recaptured as taxable income. These methods will be explained in this lesson.

Please watch the following video (4:34): After Tax Cash Flow.

After Tax Cash Flow
Click for the transcript of "After Tax Cash Flow" video.

PRESENTER: In this video and following videos, I will explain how to calculate tax deductions and after tax cash flow. Tax law allows the investors to recover some unspecified types of their investment through tax deductions, meaning that the investor can take some amount of money from generated revenue as tax deductions. Types of property that may be covered over their useful life are including but not limited to building, machinery, equipment, and trucks.

If the property doesn't lose its value, it cannot be recovered through tax deductions. A good example of that is bank accounts or land. If you buy land, it is assumed that the land value is not going to be lower after a couple of years. So you're not allowed to recover the amount of money that you paid for the land through tax deductions.

So there are two main categories of investments that can be-- that are allowed to be recovered through tax deductions. The first category is called investments that can be expensed. Expensed means they can be recovered in full amount in the year that they happen. An investor can deduct that expense, that investment, in full amount, from the revenue in the year that investment has occurred.

The other type of investments are the ones that can be capitalized. Capitalized means they can be deducted over more than one year as tax deductions. So the difference between investments that can be expensed from the investments that can be capitalized is just the time.

Here, we can see business costs that can be expensed. They can be deducted in full amount in the year that they happen-- operating costs, research and experimental costs, mining, exploration costs, mining development costs, petroleum intangible drilling costs, or IDC. Depreciation, depletion, and amortization are methods to capitalize the business costs. And essentially, they do the same thing.

But they are applicable to different categories of costs-- for example, acquisition costs and lease bonus costs or paid for mineral rights or natural resources. They can be recovered by depletion, and costs such as acquiring a business lease or trademark expenses, they can be recovered by amortization. So it is obvious that the faster investors recover their expenses, it's better for them. It is going to have positive economic effect on the project. For example, if there is no limitation in recovering the investments, investors would prefer to recover all their costs, all the investment, in full amount in the year that they are paying that because the earlier you get your money back, it has higher value than when you get it in a later future.

Credit: Farid Tayari

In general, After-Tax Cash Flow requires the following calculations:

Revenue
- Operating Costs
- Depreciation
- Depletion
- Amortization
- Write-offs
————————————————
Taxable Income
- Income Tax
————————————————
Net Income
+ Depreciation
+ Depletion
+ Amortization
+ Write-offs
- Capital Expenditures
————————————————
After-Tax Cash Flow (ATCF)

Where, Depreciation, Depletion, Amortization, and Write-offs are called Non-cash capital cost deductions. ATCF can be written in form of equation as:

After-Tax Cash Flow=Net Income+Non-Cash deductions–Capital cost
Equation 7-1 

Or

After-Tax Cash Flow=Sale Revenue–Operating Costs–Income Taxes–Capital Costs
Equation 7-2

As explained in Example 7-2 and 7-3, depending on the characteristics of investment, Before-Tax Cash Flow and After-Tax Cash Flow calculations might be different and may give different economic results.

Italicized sections are from Stermole, F.J., Stermole, J.M. (2014) Economic Evaluation and Investment Decision Methods, 14th edition. Lakewood, Colorado: Investment Evaluations Co.