Introduction to Finance

Operating Cash Flows
Investing Cash Flows
Year
Net 
Income
+
Depreciation
_
Change in 
NWC
Change in 
Fixed Assets
=
Total 
Cash Flow
0
$0
$0
$–3,500
$–10,000
$–13,500
1
0
2,500
0
0
2,500
2
1,500
2,500
0
0
4,000
3
2,500
2,500
0
0
5,000
4
4,000
2,500
0
12,000
18,500
If 12 percent is your required rate of return, the NPV of this endeavor is $7,236.90, so 
your personal wealth should rise from opening the ice cream shop.
Depreciation as a Tax Shield 
Depreciation plays an important role in determining 
operating cash fl ow. As discussed above, it is a noncash expense. By deducting depreciation 
expenses, a fi rm lowers its pretax income (earnings before taxes, or EBT), its tax bill, and its 
net income, and it increases its operating cash fl ow. A short example will show how this de-
duction 
lowers
net income but 
raises
operating cash fl ow.
Suppose JohhnyJim Products has $1,000 in sales and expenses for wages and supplies of 
$300. Let’s see how a depreciation expense of $100 aff ects its profi tability and its net income. 
Table 17.7
shows two income statements: one without depreciation expense and another with 
depreciation expense. To simplify the example, we will assume the change in net working 
capital is zero and that JohnnyJim’s tax rate is 40 percent.
Using equation 17-4, JohnnyJim’s operating cash fl ow with depreciation is the following:
Cash fl ow from operations = Net income + Depreciation – Change in net working capital
= $360 + $100 – $0 = $460
Its operating cash fl ow without depreciation is the following:
Cash fl ow from operations = Net income + Depreciation – Change in net working capital
= $420 + $0 – $0 = $420
Although depreciation lowers its net income, JohnnyJim’s operating cash fl ow is $40 higher 
with depreciation expense than without depreciation expense. The reason the operating cash 
fl ow with depreciation is $40 higher is because JohnnyJim’s tax bill is $40 lower. By lowering