What is the net change in Cash Flow from Operations after depreciation and interest in Year 2 with a 40% tax rate?

What is the net change in Cash Flow from Operations after depreciation and interest in Year 2 with a 40% tax rate?

• A. Up by $2
• B. Up by $12
• C. Down by $40
• D. Down by $2

Answer: (D)

The change in Cash Flow from Operations from depreciation and interest comes from two opposing tax-related effects: depreciation creates a tax shield that increases cash flow, while interest expense is a cash outflow (though its deduction also reduces taxes). To compare them on a like-for-like basis, use the after-tax impact. The depreciation amount reduces taxable income, saving taxes equal to the tax rate times depreciation, which boosts cash flow by T × D. The interest expense, being a cash outlay, reduces after-tax cash flow by I × (1 − T), because taxes save a portion of that outflow. Net effect on cash flow from operations for these two items is T × D minus (1 − T) × I. With a 40% tax rate, that becomes 0.4 × D − 0.6 × I. In Year 2, this calculation yields a negative result of 2 dollars, meaning the after-tax cost of interest outweighs the depreciation tax shield by 2 dollars. Hence, cash flow from operations declines by $2. If depreciation were much larger relative to interest, the net could be positive; if interest dominates, the net would be more negative.

The change in Cash Flow from Operations from depreciation and interest comes from two opposing tax-related effects: depreciation creates a tax shield that increases cash flow, while interest expense is a cash outflow (though its deduction also reduces taxes). To compare them on a like-for-like basis, use the after-tax impact.

The depreciation amount reduces taxable income, saving taxes equal to the tax rate times depreciation, which boosts cash flow by T × D. The interest expense, being a cash outlay, reduces after-tax cash flow by I × (1 − T), because taxes save a portion of that outflow. Net effect on cash flow from operations for these two items is T × D minus (1 − T) × I. With a 40% tax rate, that becomes 0.4 × D − 0.6 × I.

In Year 2, this calculation yields a negative result of 2 dollars, meaning the after-tax cost of interest outweighs the depreciation tax shield by 2 dollars. Hence, cash flow from operations declines by $2. If depreciation were much larger relative to interest, the net could be positive; if interest dominates, the net would be more negative.