In addition to the strategic issues regarding Capex, there are at least two other levels to Capex analysis—screening and selection. Screening is the process of determining whether a proposed Capex investment meets the firm’s basic investment criteria. Selection is the harder task of choosing among the various Capex projects that meet initial screening requirements. Effective capital budgeting at both the screening and selection levels has long been one of cash flow’s analytical advantages over profitability. There are a couple of worthwhile techniques for capital budgeting, and although it is beyond the scope of this book to present those methodolo-gies, it’s worth noting that each is clearly based on measuring and assessing the cash flows involved. In doing cash-flow-based capital budgeting, there are two particular things worth remembering: depreciation—especially accelerated depreciation as a tax shield—and the concept of after-tax effect. Depreciation as a tax shield is simply based on the noncash nature of depreciation expense when calculating cash flows.

So, for example, when you calculate the cash flows in and out resulting from any investment decision, depreciation on a purchased asset never figures into the equation because it is not a cash cost. The concept of the aftertax effect means that an expense that is tax-deductible really doesn’t cost what you pay for it; instead, it costs what you pay less the taxes you save on the higher profit you would have reported without the expense. So, for example, the interest portion of your mortgage payment this month doesn’t really cost you the $1,000 that you pay the bank. Instead, it costs you $1,000 minus, say, $380 tax savings created by a 31% tax rate on your federal return and 7% on your state income-tax return. That is how much higher your taxes would be if you didn’t have the mortgage-interest deduction.

Taken From : Cash Rules