Taxes, insurance and cash flow

Why it matters

A project is judged by the cash it returns to the company after all bills and taxes are paid, not by its accounting profit. Income tax typically takes a large share of profit, insurance and property taxes are fixed charges paid whether or not the plant runs, and depreciation — though not paid to anyone — changes the tax bill. Getting from revenue to after-tax cash flow correctly is the step on which payback, NPV and IRR all depend.

Key ideas

Taxes that affect a plant.

• Income (corporate) tax on taxable profit — the largest. The rate is set by law and changes; in a problem it is given data.
• Property and local taxes on land and buildings — a fixed charge, often 1–4% of fixed capital per year.
• Indirect taxes (GST, excise, customs duty on imported equipment) — usually passed through in prices or added to equipment cost; customs duty and freight belong in the delivered cost of equipment.

Insurance. Plants insure property (fire, explosion, natural disaster), liability to third parties, and loss of profit through business interruption. The premium, often about 0.4–1% of fixed capital per year depending on the hazard, is a fixed charge in the total product cost. Good safety design lowers premiums.

From revenue to profit.

• Gross profit (before tax) = revenue − total product cost, where TPC includes depreciation.
• Income tax = tax rate × taxable profit (taxable profit uses the depreciation allowed by tax rules).
• Net profit (after tax) = gross profit − income tax.

Cash flow. Depreciation is deducted to compute tax but no cash leaves the company, so it is added back: annual cash flow = net profit + depreciation. Equivalently, cash flow = (1 − t)(revenue − cash costs) + t·D. The term t·D is the depreciation tax shield: each rupee of depreciation saves t rupees of tax. This is why faster depreciation raises the present worth of a project.

If the company makes a loss in a year, tax is zero for that year (or the loss is carried forward against later profits, as the tax rules allow); in simple problems assume tax is not negative unless told that the company can offset the loss against other income.

Cash flow over the project life. A cumulative cash-flow diagram plots the company's running cash position against time:

• during design and construction the curve falls as fixed capital is spent;
• at start-up working capital is spent (and land, if bought);
• once production starts the curve rises with slope equal to the annual cash flow;
• at the end, working capital, land value and salvage value are recovered. The point where the curve crosses zero is the break-even (payback) point; the final height is the net (undiscounted) cash position. Discounting each year's cash flow gives the NPV, treated in the profitability topic.

Working-capital changes. If working capital rises during a year (more stock, more credit to customers), cash is tied up and cash flow is lower than net profit + depreciation by that increase; a fall in working capital releases cash.

Formulas

Gross profit P_g = R − C_cash − D Income tax T = t·P_g (for P_g > 0) Net profit P_n = (1 − t)·(R − C_cash − D) Cash flow CF = P_n + D = (1 − t)·(R − C_cash) + t·D CF with working-capital change = P_n + D − ΔWC Depreciation tax shield = t·D Insurance or property tax = fraction × FCI

Symbols: R annual sales revenue (₹/yr), C_cash annual cash costs (TPC excluding depreciation, ₹/yr), D annual depreciation (₹/yr), t income-tax rate (decimal), ΔWC increase in working capital during the year (₹/yr), FCI fixed capital investment (₹). Use the same year's revenue, costs and depreciation.

Worked examples

Example 1 (standard). A plant has annual revenue ₹12 crore, cash operating costs ₹7 crore and depreciation ₹2 crore. Income tax is 30%. Find gross profit, tax, net profit and cash flow.

1. P_g = R − C_cash − D = 12 − 7 − 2 = ₹3 crore.
2. T = 0.30 × 3 = ₹0.9 crore.
3. P_n = 3 − 0.9 = ₹2.1 crore.
4. CF = P_n + D = 2.1 + 2 = ₹4.1 crore.
5. Check: (1 − t)(R − C_cash) + t·D = 0.7 × 5 + 0.3 × 2 = 3.5 + 0.6 = 4.1.
6. Net profit ₹2.1 crore/yr; cash flow ₹4.1 crore/yr (of which ₹0.6 crore is the depreciation tax shield).

Example 2 (GATE level). FCI = ₹40 crore including ₹2 crore of land; working capital ₹6 crore; both spent at start-up. Life 5 years, straight-line depreciation to zero salvage (land not depreciated). Annual revenue ₹50 crore, annual cash costs ₹30 crore, tax 30%. Find the annual cash flow and the cumulative cash position at the end of the project, when working capital and land are recovered.

1. D = (40 − 2)/5 = ₹7.6 crore/yr.
2. P_g = 50 − 30 − 7.6 = ₹12.4 crore/yr; P_n = 0.7 × 12.4 = ₹8.68 crore/yr.
3. CF = 8.68 + 7.6 = ₹16.28 crore/yr.
4. Cumulative position = −(40 + 6) + 5 × 16.28 + 6 + 2 = −46 + 81.4 + 8 = ₹43.4 crore.
5. The cumulative curve crosses zero after 46/16.28 = 2.83 years of operation.
6. CF = ₹16.28 crore/yr; final cumulative cash position = +₹43.4 crore.

Common mistakes

• Taxing revenue minus cash costs without first deducting depreciation (overstates tax).
• Treating depreciation as a cash outflow, or forgetting to add it back after tax.
• Depreciating land or working capital, or forgetting to recover them at the end.
• Using a negative tax in a loss year when the question does not allow loss offset.
• Counting insurance twice — once as a fixed charge and again in overhead.

For GATE CH

Expect one- or two-step numericals: net profit and cash flow from revenue, costs, depreciation and tax rate; the effect of a change in depreciation or tax rate on cash flow; cumulative cash position at the end of a project. Practise the identity CF = (1 − t)(R − C) + tD; it often shortens the working.

Quick check

1. R − C_cash = ₹10 crore, D = ₹4 crore, t = 25%. Cash flow?
2. Why does depreciation increase cash flow when it is "only a book entry"?
3. Insurance at 0.8% of FCI = ₹50 crore. Annual premium?
4. Which items are recovered at the end of a project in a cash-flow diagram?

Answers: 1. 0.75 × 10 + 0.25 × 4 = ₹8.5 crore. 2. It lowers taxable profit, so less tax is paid (tax shield t·D). 3. ₹0.4 crore. 4. Working capital, land and salvage value.