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Cash flow concept -where to apply (1-t) and where to apply t

Mohit (CA) (755 Points)

22 June 2013

Hi Guys,

Will be really grateful if somebody could solve my doubt. My question is in cases of Capital budgeting (Cash flows) why in the case of depreciation cash flow is multiplied by tax rate while other cases such as Interest costs it is multiplied by (1itax rate).

What is the reason of doing this though both are P&L debit items. Also what are the possible examples where we multiply by only tax rate and cases where we multiply by (1-tax rate?)

Mohit

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3 Replies

@sh jais (live the life otherwise life leaves u.....) (1539 Points)
Replied 22 June 2013

dear mohit... Depriciation is non cash item.. Bcoz the no outflow of cash when we charged dep on book dear... But interest we pay and there is outflow of cash... thats y cash flow approch dep save the tax if dep is not charged in pl than company has to pay more tax.. So due to dep there is saving of tax... Same principle apply with all pl item but other are cash outflow item like interest..

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Mohit (CA) (755 Points)
Replied 23 June 2013

Thanks... But i am really not clear with the concept. Could you explain with some expample wth figures. Not getting how it works at all..

Mukul (CA FINAL) (66 Points)
Replied 24 June 2013

Hi Mohit...
Don't look at Interest & Depreciation being P and L items.... that perspective for CASH FLOW ANALYSIS is wrong....
Keep this Question in Mind..... "Is CASH coming IN or going OUT? " for all expenses and Incomes...
In your case...
Interest.... we multiply it by (1-tax rate)....because when we pay interest...CASH IS GOING OUT.....BUT when we pay Interest....we are incurring an EXPENDITURE which gives us TAX SAVINGS.... which is an indirect INFLOW. So if Your Interest amount is say Rs. 10,000 and your Tax Rate is 30%....then your CASH Outflow is Rs.10,000, also you will have a Tax Saving(Inflow) of 30% on Rs.10,000 i.e. Rs.3,000...which makes yours Net Cash Outflow Rs.7,000.... so in short......Interest*( 1 -tax rate) = 10,000*(1-0.3) = 7,000

Whereas for Depreciation we Multiply it directly by Tax Rate because of the answer to the same Question I mentioned earlier....IS CASH COMING IN OR GOING OUT?....and i Hope you know, when we account for Depreciation...THERE IS NO CASH FLOW....but there is a SAVINGS IN TAX because Depreciation is a P and L Item....therefore Depreciation * Tax Rate gives you the TAX SAVED on such Depreciation....which is an Indirect INFLOW....
The FORMULAE are just the simplified Versions of such huge Explanations...

Hope this Helps... All the BEST!!!