Estimating project cash flows and taxes

A capital budgeting decision is only as good as the cash flow forecast behind it. The decision rules of lesson 7 tell us to discount a project's cash flows, but which cash flows? This lesson sets out the principles for identifying the cash flows that belong in the analysis, shows how to build a project's free cash flows year by year, and explains how taxes, especially the tax deductions for capital spending, change the result. The tax rules differ sharply between Canada and the United States, so this lesson uses each country's system on its own site. Nothing here is tax advice; rules change often, and real projects need current rules and professional advice.

Incremental cash flows

The cash flows that matter are incremental: the difference between the firm's cash flows if it takes the project and its cash flows if it does not. Every item in the analysis should pass that test. Several common traps follow from it. Sunk costs, money already spent and unrecoverable whatever the decision, are irrelevant: a market study paid for last year should not count against the project. Opportunity costs are relevant: if the project uses land the firm already owns, the cash the firm could get by selling or renting that land is a cost of the project, even though no check is written. Side effects matter: a new product that takes sales from an existing one (cannibalization) should be charged with the lost profit, while one that boosts sales of other products should be credited with the gain. Allocated overhead counts only to the extent that the project actually increases it.

Financing costs are excluded from project cash flows. Interest, debt repayments and dividends are payments to investors, and the required return of those investors is captured in the discount rate, the weighted average cost of capital developed in lesson 11. Subtracting interest from the cash flows and also discounting at a rate that includes the cost of debt would count it twice. Finally, be consistent about inflation, as lesson 3 explained: if revenues and costs are forecast in nominal dollars that include expected price increases, discount at a nominal rate.

The parts of a project's cash flows

A project's free cash flow in each year has three parts, matching the free cash flow definition of lesson 2. The first is after-tax operating cash flow: incremental revenue minus incremental cash operating costs, minus the taxes on that difference. The second is the tax saving from deducting the cost of the capital assets over time, called the depreciation tax shield, or in Canada the capital cost allowance tax shield. The third is investment: the capital spending at the start (and any later), the investment in net working capital, and their recovery at the end through the after-tax salvage value of the assets and the release of the working capital.

Here \( D_t \) is the tax deduction for the capital asset in year \( t \) and \( T \) the marginal tax rate. The term \( T \cdot D_t \) shows that depreciation itself is not a cash flow, but its effect on taxes is: each dollar deducted saves \( T \) dollars of tax. Working capital is usually invested at the start or as sales grow and recovered at the end of the project, when inventory is sold off and receivables are collected; ignoring it overstates the NPV of almost any project, because it moves cash from early years to late years.

Tax deductions for capital spending

In the United States, the tax deduction for most tangible business property follows the Modified Accelerated Cost Recovery System (MACRS). Assets are assigned to recovery periods (3, 5, 7, 10, 15, 20, 27.5 or 39 years) with prescribed percentages; for example, machinery is commonly 7-year property and computers and vehicles 5-year property, depreciated with the 200 % declining balance method and a half-year convention. On top of MACRS, bonus depreciation lets firms deduct a percentage of the cost immediately. The 2017 Tax Cuts and Jobs Act allowed 100 % bonus depreciation, phasing down from 2023 (80 %) to 2024 (60 %) and early 2025 (40 %); the One Big Beautiful Bill Act of July 2025 made 100 % bonus depreciation permanent for qualifying property acquired after January 19, 2025. Section 179 also allows small and mid-sized firms to expense qualifying property up to an annual limit ($2.56 million in 2026, phasing out above about $4.09 million of purchases). Many states do not conform to federal bonus depreciation, so state taxable income can differ.

When an asset is sold, any amount above its remaining tax basis (cost minus depreciation claimed) is taxed: gains up to the depreciation claimed are recaptured as ordinary income, and in the simple case where the asset is sold for less than its original cost, the whole gain is taxed at the ordinary corporate rate. With 100 % bonus depreciation the remaining basis is zero, so the whole salvage value is taxable. A sale below the remaining basis creates a deductible loss.

A complete project analysis

Bringing the pieces together, consider a project that requires equipment costing $800,000, has a five-year life, and will be sold for $150,000 at the end. It needs $60,000 of extra working capital at the start, recovered at the end. It is expected to increase revenue by $500,000 a year and cash operating costs by $230,000 a year. The discount rate is 10 %. The tax treatment of the equipment follows each country's rules.

# Project NPV with MACRS and with 100 % bonus depreciation
cost, salvage, nwc, years = 800_000, 150_000, 60_000, 5
revenue, op_costs, tax, r = 500_000, 230_000, 0.25, 0.10
macrs7 = [0.1429, 0.2449, 0.1749, 0.1249, 0.0893, 0.0892, 0.0893, 0.0446]
def npv(dep_rates):
    total = -cost - nwc
    basis = cost
    for t in range(1, years + 1):
        dep = cost * dep_rates[t - 1] if t - 1 < len(dep_rates) else 0
        basis -= dep
        cf = (revenue - op_costs) * (1 - tax) + dep * tax
        if t == years:
            gain = salvage - basis           # taxed as ordinary income (recapture)
            cf += salvage - gain * tax + nwc
        total += cf / (1 + r) ** t
    return total, basis
for label, rates in [("7-year MACRS", macrs7), ("100 % bonus depreciation", [1.0])]:
    value, basis = npv(rates)
    print(f"{label:26s} NPV {value:10,.0f}   tax basis left at year 5 {basis:10,.0f}")

7-year MACRS               NPV    163,342   tax basis left at year 5    178,480
100 % bonus depreciation   NPV    196,561   tax basis left at year 5          0

Replacement decisions

Many capital budgeting decisions are about replacing an existing asset with a new one. The incremental cash flows are then the differences: the cost of the new machine minus the after-tax proceeds from selling the old one, the change in operating costs, the change in tax deductions, and the difference in salvage values at the end. The old machine's original cost is sunk; what matters is what it could be sold for now and what keeping it would cost in the future.

Practical forecasting

Forecasts of revenue and costs are where most capital budgeting errors begin. Managers proposing a project tend to be optimistic, and they often have an incentive to be. Good practice includes checking forecasts against the experience of past projects, asking why the firm has an advantage that will let it earn more than its cost of capital, building forecasts from specific assumptions (market size, share, price, unit costs) rather than from a target NPV, and reviewing projects after they are completed. Lesson 9 shows how sensitivity, scenario and simulation analysis expose the assumptions that matter most. And whatever the tax rules, the project should make economic sense before the tax shield: an investment that is worthwhile only because of a tax incentive is vulnerable if the rules change.