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The annual after-tax expected cash flows for the project are: Annual cash savings after tax: $28,400 × .60 $17,040 Increase in annual depreciation tax shield: $14,400 increase in annual depreciation × .40 5,760 Total annual after-tax cash flows $22,800
This is the increase in the after-tax cash flow resulting from the cost savings. This is not the only after-tax cash flow for the project. The increase in the annual depreciation will cause an increase in the depreciation tax shield.
This is the $16,000 annual depreciation on the new equipment subtracted from the $28,400 annual cash savings, and then the difference is multiplied by 1 ? the tax rate (.60). Depreciation does not reduce cash flow, because it is a non-cash transaction. Because of the depreciation tax shield, depreciation causes an increase in cash flow. Furthermore, the relevant depreciation amount is the amount by which depreciation will change as a result of the new equipment.
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Annual after-tax cash flows for the project would amount to