Question

. Explain why an analyst should always focus on after-tax cash flows (rather than pre-tax cash flows) when analyzing a potential investment. What would you say to someone who claimed that pre-tax cash flows were more important?

Answer 1

At the time of analysing a potential investment the focus should be on after tax cash flows because tax plays a big role in the cash flows of an investment. The tax which is saved on expenses should be taken into account since that is a cash saving for the business. Similarly tax which is to be paid on revenues have to be taken into account because that is additional expense.

A major factor which should be taken into account while computing cash flows of an investment is the tax saving on depreciation expense of the investment. Depreciation is an expense which is recognised by the Income Tax Department and is a deductible expense. Even though depreciation itself is a non cash expenditure the tax saving which arises by claiming depreciation increases the cash flow from a potential investment. Hence if the analyst considers the pre tax cash flows he will not get the correct picture of the investment and the decision of investing in the particular project will be incorrect.