General procedure for after-tax analysis

After-tax analysis converts before-tax cash flows into after-tax cash flows (ATCF) and then applies PW, AW or IRR at the after-tax MARR.

General procedure

1. Estimate the before-tax cash flows (BTCF): investment, revenues, O&M costs and salvage value.
2. Choose the depreciation method (SL, DB, SOYD, MACRS) and compute depreciation for each year.
3. Compute taxable income = revenue − O&M expenses − depreciation (− interest if debt financed).
4. Compute income tax = taxable income × tax rate (a negative value is a tax saving if the firm has other taxable income).
5. Compute ATCF = BTCF − income tax. Add the tax effect of disposal: gain on sale (selling price − book value) is taxed; a loss gives a tax saving.
6. Draw the ATCF diagram and calculate PW, AW or IRR using the after-tax MARR.
7. Accept if PW ≥ 0 (or after-tax IRR ≥ MARR); for alternatives choose the best by the usual method.

Example

A machine costs Rs 1,00,000, lasts 4 years with zero salvage value, and gives Rs 50,000 per year before tax. Tax rate = 40%; SL depreciation; after-tax MARR = 8%.

Depreciation = 1,00,000 / 4 = 25,000
Taxable income = 50,000 − 25,000 = 25,000
Tax = 0.40 × 25,000 = 10,000
ATCF = 50,000 − 10,000 = 40,000 per year (years 1 to 4)
PW = −1,00,000 + 40,000(P/A,8%,4) = −1,00,000 + 40,000(3.3121) ≈ +32,485

PW > 0, so the project is acceptable after tax. (Before-tax cash flow 50,000 gives PW = +65,606, which shows how tax reduces the return.)