# ## A Brief Guide to Engineering Financial Calculations: After-Tax Cash Flow

Key Assumptions

After-tax cash flow is discussed for revenue from normal operations, i.e., earnings before interest and taxes is considered to be the same as operating income.

The tax implications of Other Income depend on the specific situation (including how interest is earned and booked as Other Income), and so its tax is handled on a case-by case basis and not discussed further here.

In some cases, depreciation may have been booked as a non-cash expense in Operating Income. In that case, the taxable cash flow from operations will be the sum of operating income with depreciation and other non-cash expenses added back in.

Calculation:

For each year, the after-tax income involves a set of calculations:

1) Take the Operating Income and adjust for any expenses that are not eligible for tax deductions (e.g. some kinds of meal expenses). Interest on loans is a taxable expense.

2) Add depreciation back into the Operating Income (if necessary) to give the taxable cash flow from operations. (If inflation is a factor, then Operating Income is corrected for inflation before doing the taxation calculations in subsequent steps.)

3) Calculate the Capital Cost Allowance (CCA) for each class of capital costs (using the Canada Revenue Agency guidelines). (See Depreciation for Tax Purposes in the section on depreciation in this guide for details on how to do that calculation.)

4) Deduct the CCA (up to the limit of net income from all sources) to get the taxable income. Taxes for an incremental cash flow may actually be negative, if enough other sources of income exist in the company from which to deduct taxes. (See the section below if there is disposal of an asset in the year being considered.)

5) Calculate income tax payable based on taxable income and the applicable percentage tax rates for the business.

6) Deduct the income tax from taxable income to get net income after tax for the year of interest. This is the after-tax cash flow for that year.

This set of steps is done for each period (generally annually) over set of intervals in time to give a series of after-tax cash flows, which is a set of future sums. For a series of after-tax cash flows, the NPV is calculated using the same procedures as for any other time-series of future sums.

Accounting for Salvage Value

Because CCA is calculated using declining balance (i.e., it carries on forever), disposal of assets is not straightforward. A disposal tax effect (DTE) is included to account for the fact that salvage value is either a loss or a gain in the year \$\boldsymbol{t}\$ in which it occurs. DTE in year \$\boldsymbol{t}\$ is equivalent to the difference between the salvage value and the UCCt book value multiplied by the tax rate \$\boldsymbol{TR}\$:

DTE = (UCCt – SalvageValue) x TR

The After Tax Cash Flow in that year includes the Salvage Value and the DTE:

ATCF = ATCFNominal + Salvage Value + DTE

Three cases are of interest:

1. If an asset is sold for less than its UCCt value, then theDTE is positive.

DTE = (UCCt – SalvageValue) x TR            (positive, so ATCF ↑)

2) If an asset is sold for greater than its UCCt value, then theDTE is negative (salvage value is larger than remaining unclaimed capital cost), meaning the tax effect is a recapture of what was allowed previously (Tax n Recapture), and so there an increase in taxes (i.e., ATCF is reduced by DTE).

DTE = (UCCt – SalvageValue) x TR            (negative, so ATCF ↓)

3) If an asset is sold for greater than its purchase price (Basis Value), then the DTE is negative (as in case 2 above), but the DTE is equal to the sum of two tax effects, tax on recapture, and capital gains tax. These are tracked differently, because the capital gains tax rate is only half of the normal tax rate:

Tax On Recapture = (UCCt – BasisValue) x TR

Capital Gains Tax = (BasisValue – Salvage Value) x TR / 2

DTE = Tax On Recapture + Capital Gains Tax

Loan Principal Repayment:

When a loan is taken out, there is an agreed schedule for payments. Mortgage payments are generally done on a level payment basis. Each payment is the same; and that payment will be the sum of the interest on the remaining principal amount for the period, plus some repayment of the principal. Because part of the principal gets paid off, the interest amount goes down over time and more of the payment goes toward paying down the remaining principal amount.

The interest part of a payment in a particular period is the principal for that period times the interest rate. The mortgage payment minus the interest is applied to repayment of the principal, and so the principal for the next period is the current principal minus the repayment.

Because interest is a taxable expense, the cost of interest is subtracted from income before debt service (that’s the interest portion only, not the principal repayment part). That pre-tax net income then has the taxes subtracted (at the tax rate) to yield the after-tax net income. The cash flow after tax is typically the after-tax net income with depreciation added back in (a simplification of the real world).

Principal repayment is done using after-tax dollars, and so

Cash flow after tax and principal repayment = Cash flow after tax – principal repayment.