Tax Shield Approach

This approach allows us to calculate free cash flow directly by focusing on the tax savings to the firm resulted from depreciation expenses.

• Particularly useful when major FCF are the cost of equipment, e.g., in office automation, and replacement decision.
• $\text{Depreciation tax shield}=\text{Depreciation}\times t_c$
  • The cash flow effect of depreciation is reducing taxes.

Incremental earnings approach:

$$\begin{array}{rl}\text{Incremental FCF}& =(\text{Revenues}-\text{Costs}-\text{Depreciation})(1-t_c)\\ & +\text{ Depreciation}\\ & -\text{ Net Capital Expenditures}\\ & -\Delta \text{NWC}\end{array}$$

Tax shield approach:

$$\begin{array}{rl}\text{Incremental FCF}& =(\text{Revenues}-\text{Costs})(1-t_c)\\ & +t_c\times \text{Depreciation}\\ & -\text{ Net Capital Expenditures}\\ & -\Delta \text{NWC}\end{array}$$