FIN 44 Project Analysis and The Tax Shield

Let's jump into module seven, a module on project analysis. So this module brings to bear a lot of what we have learned so far. And it builds on the last chapter. The key concept from the last chapter was net present value, present value of future cash flows to determine if a project is worth doing. Well, what's project analysis? We're determining if a project is worth doing. So what's different between this and last chapter? The difference is this chapter, we have to calculate those future cash flows. They won't just be given in the question. We got to do a bit of work from company financial statements or projected financial statements, what we learned in chapter two and calculate cash flow. And we actually learned to do that in chapter one. So a lot of modules sort of coming together in this chapter, but there is one new concept. And that new concept is frequently confused because it's counterintuitive and confusing. So I wanted to introduce a new concept in this video. And that concept is called the tax shield. And you will have heard this if you've worked through problems in a corporate finance class, the phrase tax shield comes up all the time. And it's something that at least I struggled with. And sometimes I see students struggling with. So I wanted to introduce it here. If you feel good about the tax shield, just skip ahead and go on to like some examples from the chapter. But if tax shield is something you haven't heard of before, it's something that maybe you have heard of and it confused you. I hope I can bring some clarity to the situation. I'm gonna try. We'll see if I bring clarity to the situation. So I wanted to prepare two income statements. One is the company's actual income statement. The green one there is a thought exercise I wanna go on. And this thought exercise will help me explain the concept of the tax shield. So let's, again, this is a pretend company. This is a pretend income statement. And some of the assumptions are pretend, right? Like revenues, all cash. Well, not all revenues are always all cash, but for our example, okay? Because we're finance folks, we're interested in cash. So I wanna make it as simple as possible. Our revenues are all cash. Our costs are all cash. Depreciation is not for cash. And you can see income taxes are indeed for cash. So if I just look at the cash items here and look at the cash flow for this company, it's 100,000, that's cash, 70,000, that's cash. Okay, depreciation, non-cash. The subtotal's non-cash, but tax is cash. So if I just go revenues minus costs minus tax, I get $27,000 and I would say, okay, my cash flow is, again, 100,000 in, 70 and three out, 73 out. I'm at 27 in cash flow. So the cash this company generated this year would have been a plus 27,000. You could calculate that any number of ways, right? We've done a lot of operating cash flow calculations before in this class and there we have it. We've arrived at cash going up 27,000. Now, as a thought exercise, what if, let's pretend there's no depreciation in this company. Everything else is the same, but this company does not have depreciation. All right, so if we don't have depreciation, we're more profitable. Our net income, as you can see here, is significantly higher, right? $14,000 higher, because we don't have depreciation, so 100 minus 70 is 30. We do pay 30% tax, so $9,000 in tax, and that brings us to 21,000. Let's look at cash flow. So let's look at the items composing our cash flow. So something that I would think is, okay, well, without depreciation, I'm more profitable. That's good, I would think. Yes, having low depreciation is good, but from a cash flow perspective, depreciation, even though it's an expense, is good for cash flow. Depreciation makes cash flow go up, as we will soon see. So let's look at our cash items. So revenues, all cash, 100 grand. Costs, 70 grand, so 100 minus 70 is 30. Taxes are nine. So in fact, this whole income statement was just cash flow. Our cash in scenario two was plus 21,000. 100 minus 70 minus nine is 21,000. So why would that be? I had fewer expenses here, right? $20,000, fewer expenses, and yet my cash situation is worse because I eliminated the depreciation. Well, depreciation shields us from tax. It's an expense that doesn't involve cash, so it makes your net income go down. In making your net income go down or your taxable income go down, that reduces your tax bill, which is a cash expense. And you can see the difference in taxes there. Three to nine, it's $6,000 different, and that's the difference here. So how do I calculate my tax shield? I just go 30%, the tax rate, times the depreciation amount, which is $20,000. The tax shield here is $6,000. So depreciation shielded us from $6,000 of tax. That's what the tax shield is trying to say. It is, at least for me, something I have to twist my mind to come to, but the best way to learn any of this stuff is to do lots of examples, and I've got lots of examples waiting for you in this chapter. So stay tuned for the next video. Bye for now. Gotta find the stop button. Where's my mouse? Bye for now.