What Is 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 along with the applicable marginal tax rate.
Discounted after-tax cash flow is similar to simple discounted cash flow (DCF), but here tax implications are also taken into consideration.
- Discounted after-tax cash flows takes the present value of future income streams, but which have been adjusted for the expected tax liability of each cash flow.
- Using after-tax discounting provides a more realistic evaluation of a project or investment's attractiveness, and may also account for non-cash flows such as depreciation.
- Discounted after-tax cash flows are used to calculate the profitability index as well as the discounted payback period of a project or investment.
Understanding Discounted After-Tax Cash Flows
The purpose of discount analysis is to estimate the money an investor would receive from an investment, adjusted for the time value of money. The time value of money assumes that a dollar today is worth more than a dollar tomorrow because it can be invested. As such, a DCF analysis is appropriate in any situation where a person is paying money in the present with expectations of receiving more money in the future.
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, even though it is not an actual cash flow, depreciation 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.
Discounted After-Tax Cash Flows and Profitability
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.
Because there are several 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), and income approach.
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.