DEFINITION of Discounted After-Tax Cash Flow
The discounted after-tax cash flow method is an approach to valuing an investment by assessing the amount of money generated and taking into account the cost of capital and the investor's marginal tax rate. Discounted after-tax cash flow is similar to simple discounted cash flow (DCF), but tax implications are also taken into consideration.
BREAKING DOWN Discounted After-Tax Cash Flow
The discounted after-tax cash flow approach is mostly used in real estate valuation to determine whether a particular property is likely to be a good investment. Investors must consider depreciation, the tax bracket of the entity that will own the property, and any interest payments when using this valuation method. It is a calculation of net cash flow from a property after taxes and financing costs each year have been factored in. The cash flow is discounted at the required rate of return of the investor to find the present value of the after-tax cash flows. If the present value of the after-tax cash flow is higher than the cost of investment, then the investment may be worth taking.
Since the discounted after-tax cash flow is calculated after-tax, depreciation, even though it is not an actual cash flow, must be used to determine the tax charge. Depreciation is a non-cash expense that reduces taxes and increases cash flow. It is usually subtracted from net operating income to derive the after-tax net income and then added back in to reflect the positive impact it has on the after-tax cash flow.
Because there are many different methods for valuing real estate investment, and each method has its shortcomings, investors should not rely solely on discounted after-tax cash flow to make a decision. To examine the property's value from multiple perspectives, you can also use other methods of real estate valuation such as the cost approach, sale comparison approach (SCA), an income approach.
The discounted after-tax cash flow can be used to calculate the profitability index, a ratio that evaluates the relationship between the costs and benefits of a proposed project or investment. The profitability index, or benefit-cost ratio, is calculated by dividing the present value of the discounted after-tax cash flow by the cost of the investment. The rule of thumb asserts that a project with a profitability index ratio equal to or greater than one is a potential profitable investment opportunity. In other words, if the present value of the after-tax cash flow is equal to or higher than the cost of the project, the project may be worth undertaking.
The discounted after-tax cash flow is also used to calculate the simple payback and discounted payback period of an investment, allowing an investor to determine the length of time it would take for a project to recover the initial amount invested in it.