Discounted After-Tax Cash Flow: What It Is and How It Works

Updated December 01, 2023

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Definition

Discounted after-tax cash flow is a valuation method that calculates the present value of an investment's future income streams after accounting for taxes and the cost of capital.

What Is Discounted After-Tax Cash Flow?

The discounted after-tax cash flow method is an approach to valuing an investment according to the income it generates and accounting for the cost of capital and any taxes. In that way, discounted after-tax cash flow is similar to simple discounted cash flow (DCF), but with taxes factored in.

Key Takeaways

Discounted after-tax cash flow represents the present value of future income streams from an investment, adjusted for any expected tax liability.
Using after-tax discounting provides a more realistic evaluation of an investment's attractiveness, and may also account for non-cash flows such as depreciation.
Discounted after-tax cash flows can be used to calculate the profitability index as well as the discounted payback period of an investment.

Understanding Discounted After-Tax Cash Flow

The purpose of a discounted cash flow analysis is to estimate the money an investor would receive from an investment, accounting for the 澳洲幸运5开奖号码历史查询:time value of money. The time value of money assumes that a dollar today is worth more than a dollar tomorrow because it co🍸uld be invested and earning money in the meantime.

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. When using this valuation method, investors consider 澳洲幸运5开奖号码历史查询:depreciation, the 澳洲幸运5开奖号码历史查询:tax bracket of the person or entity that will own the property, and any interest payments🃏 on the capital required to make the purchase.

After calculating the net cash flow from a property each year, with taxes and financing costs factored in, the cash flow is then discounted at the investor's 澳洲幸运5开奖号码历史查询:required rate of return (RRR) to find the 澳洲幸运5开奖号码历史查询:present value of the after-tax cash flows. Required rate of return, also known as a 澳洲幸运5开奖号码历史查询:hurdle rate, is often determined by the investor's 澳洲幸运5开奖号码历史查询:weight🧜ed average cost of capital (WACC), or how much the investor must pay to borrow money. If the present value of the after-tax cash flow is higher than the cost of investing, then the investment may b🃏e worth making.

Since the discounted after-tax cash flow is calculated after taxes, depreciation must be accounted for in determining the tax cost, even though depreciation is not an actual cash flow. Depreciation is a 澳洲幸运5开奖号码历史查询:non-cash expense that reduces taxes and increases cash flow. It is usually subtracted from 澳洲幸运5开奖号码历史查询: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 flow is also used to calculate the 澳洲幸运5开奖号码历史查询:discounted payback period of an investment, allowi♏ng an investor to estimate the length of time it would take them to recover the investment's initial cost.

Discounte💛d After-Tax Cash Flows♎ and Profitability

Discounted after-tax cash flow can be used to calculate the 澳洲幸运5开奖号码历史查询:profitability index, a ratio that evaluates the relationship between the costs and benefits of a proposed investment. The profitability index, or benefit-cost ratio, is calculated by dividing the present value of th꧒e discounted aft𒉰er-tax cash flow by the cost of the investment.

As a general rule, an investment with a profitability index ratio equal to or greater than one is considered a potentially profitable opportunity. In other words, if the present value of𝓡 the after-tax cash flow is equal to or higher than the cost of the investment, the investment may be worth undertaking from a fin😼ancial perspective.

What Is After-Tax Cash Flow vs. Discounted After-Tax Cash Flow?

After-tax cash flow is how much cash remains after subtracting operating costs, borrow♕ing costs, and taxes from gross revenue. Discounted after-tax cash flow, on the other hand, incorporates a discount rate to♎ reduce future revenues to their present value.

How Does Depreciation Work in Real Estate?

Owners of an income-producing property, such as an apartment building, are allowed to depreciate, or take a tax deduction for a portion of the property's value, each year. Depending on which depreciation method they use and how long they have held the property, they can write it off over a 27.5-year, 30-year, or 40-year period. If they sell the property, however, they may be subject to 澳洲幸运5开奖号码历史查询:depreciation recapture, in the form of a tax on any profit they make.

What Is the Cost Approach in Real Estate Valuation?

The 澳洲幸运5开奖号码历史查询:cost approach in real estate valuation bases the value of a property on what it would cost to build a very similar property, including the price of the land. There are two basic methods that can be used in the cost approach. The 澳洲幸运5开奖号码历史查询:reproduction method calculates cost based on replicating the property using similar materials. The replacement method calculates the cost of building a property of similar utility but with new materials and building techniques. Property insur✃ers use a version of the cost approach in settin🎶g the premiums for homeowners and commercial insurance policies.

What Is the Sales Comparison Approach (SCA) in Real Estate Valuation?

The 澳洲幸运5开奖号码历史查询:sales comparison approach (SCA) in real estate valuation calculates the value of a property based on what comparable properties (referred to as "comps") in that area have recently sold for. It is commonly used by real estate appraisers and agents in putting a value or setting a price on residential property and is required by some lenders and mortgage underwriters.

What Is the Income Approach in Real Estate Valuation?

The 澳洲幸运5开奖号码历史查询:income approach in real estate evaluation is used to set a value on income-producing properties, such as an office building or apartment complex. It's calculated by dividing the property's 澳洲幸运5开奖号码历史查询:net operating income (NOI) by a 澳洲幸运5开奖号码历史查询:capitalization rate, or cap rate.

Net operating income is the r🐟ental income produced by the property minus the costs of maintaining it.

The capitalization rate represents the expected return on a particular real estate investment. It is calculated by dividing the property's net operating income by its current market value.

The Bottom Line

There are several different methods for valuing real estate investments, and each has its shortcomings. Investors should not rely solely on discounted after-tax cash flow to make a decision about a particular property. To examine the property's value from multiple perspectives, they can also use other methods of real estate valuation, such as the cost approach, sales comparison approach (SCA), and income approach.

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