Tax shield on Depreciation in IRR Calculation

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Rajiv (Querist)

29 July 2010 Under normal calculation why don't we add tax savings on depreciation under calculation of Total Cash inflows and outflows??
We use the net cash inflow/outflow to calculate IRR and it include tax shield on interest as outflow.
Why tax shield on depreciation not included????

Thrissurkkaran Ishtan

Thrissurkkaran Ishtan (Expert)

30 July 2010 Tax savings on tax shield should be included as it is a "cash item".

Is it possible that in your question depreciation is added back after computing PAT?

Not sure whether your query was correctly understood by me.

Rajiv

Rajiv (Querist)

30 July 2010 Yes depreciation was added back to derive cash profit ( also other non-cash items)

But why we don't consider tax savings over depreciation in the calculation?

Thrissurkkaran Ishtan

Thrissurkkaran Ishtan (Expert)

31 July 2010 There are 2 ways it can be done.

Let us assume Profit before interest and depreciation is 100 and depreciation is 10 and interest is 20.
Let us also assume tax rate 30%. Means after tax rate is 100%-30%=70%

Can inflow in your way will be (100 X 70%) + (10 x 30%) - (20X70%) = 59
Let me explain each component
100 X 70% = 70 - Assume here that we dont anything to claim like interest or depreciation for tax purpose. In that case our profit in hand (cash profit) will be 70.
10X 30% = 3 - Now imagine that we have depreciation to came for tax purpose. We dont have any cash outflow because depreciation is non cash. But we pay save tax to the tune of 3, so we pay less tax which is a cash inflow. In other words, income tax dept loses 3 because, now we are putting a claim for depreciation.
20 X 70% = 14 - Now further imagine that we have interest to claim. Interest paid out is cash out flow which is 20. But again income dept gets paid less 6 i.e., 20X30% because we can claim. So our net outflow is only 14.

In the other way (from where your query came from) will be [(100-20)] - [(100-10-20) X 30%] =59
100-20=80 - This is the cash profit before paying tax. We made a profit of 100 and we pay out interest. So now net in hand (we have not paid tax at all) is 80
We now have to compute tax which is the only out flow left. Taxable profit is 100-10-20= 70. We pay tax on this at 30% which is 21. We consider tax saving in depreciation here as you can see.
80-21= So net in hand is 59.

The key to remember is that in both ways, you should look at what is the cash left in hand ultimately.
Hope this answers your query, please let me know, if not.

Rajiv

Rajiv (Querist)

31 July 2010 Thank you very much, Sir.
All is well now!!.. :)

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