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25.7 Incorporate Tax, Depreciation, and Working Capital Effects into Cash Flow Estimates

Incremental Cash Flows​

Capital budgeting requires estimating incremental after-tax cash flows.

Components:

  1. Initial investment (capex + installation)
  2. Working capital investment (inventory, receivables minus payables)
  3. Operating cash flows (revenue - expenses)
  4. Depreciation (affects taxes but not cash)
  5. Tax effects (tax on profit, depreciation tax shield)
  6. Terminal cash flows (salvage value, working capital recovery)

Depreciation and Tax Shield​

Depreciation reduces taxable income, creating a tax shield.

Tax Shield = Depreciation Ă— Tax Rate

Example:

  • Depreciation: €50,000 per year
  • Tax rate: 20%
  • Tax shield: €10,000

Working Capital​

Working capital (WC) investments reduce cash initially but are recovered at project end.

Example:

  • Need €30,000 inventory and €15,000 receivables
  • Increase payables by €10,000
  • Net WC investment: €35,000 (released at project end)

After-Tax Cash Flow Calculation​

Operating Cash Flow = (Revenue - Expenses - Depreciation) Ă— (1 - Tax Rate) + Depreciation

Example:

  • Revenue: €200,000
  • Expenses (cash): €120,000
  • Depreciation: €30,000
  • Tax rate: 20%
  • Operating cash flow = (€200k - €120k - €30k) Ă— 0.8 + €30k = €80k Ă— 0.8 + €30k = €94k

Terminal Cash Flow​

Include salvage value and recovery of working capital.

Example:

  • Salvage value: €20.jdesktop MD trades exam nop. Need rest still etc.**

Terminal Cash Flow Example:

  • Salvage value: €20,000 (taxed at capital gains rate if > book value)
  • Book value at end: €0 (fully depreciated)
  • Tax on salvage: €20,000 Ă— 20% = €4,000
  • Net salvage cash: €16,000
  • Working capital recovery: €35,000
  • Terminal cash flow: €51,000

Inflation and Exchange Rates​

For Luxembourg SMEs operating cross-border, consider:

  • Inflation adjustments for revenues/costs
  • Exchange rate risk (EUR vs. other currencies)
  • Use real vs. nominal cash flows consistently

Luxembourg Compliance Note​

Tax rules in Luxembourg allow accelerated depreciation for certain investments (e.g., digitalization, sustainability). Include depreciation method (straight-line, declining balance) when estimating tax shields. VAT on capital expenditures may be recoverable but affects cash timing.

Think It Through​

Why must working capital investments be included in capital budgeting analysis? How does the depreciation tax shield impact project viability?