pg. 195-197 of the Derivatives and Alternative Investments book has an example where you are determining the after tax cash flow of a real estate investment project. excerpt: “To get after tax cash flow from after-tax net income, depreciation must be added and the principal repayment component of the 59,404 mortgage payment must be subtracted” I understand why depreciation must be added - because it is a non-cash activity. But why must the principal repayment component have to be subtracted from net income to get after tax cash flow? It seems to me that you would think that it would already be included in net income. -------------------------------- expanded excerpt: Because interest is tax deductible here, calculate the first year’s interest, and then calculate after-tax net income. The amount borrowed is $560,000 = 700,00 (purchase price) x .8 (80% financing). The first year’s interest at 10 percent s then $56,000 = .1 x $560,000. After tax net income is then ($83,800 - $18,700 - $56,000) x (1 - .31) = $6,279 To get after tax cash flow from after-tax net income, depreciation must be added and the principal repayment component of the 59,404 mortgage payment must be subtracted. The principal repayment is the mortgage payment minus the interest payment, or $3,404 = $59,404 - $56,000. Thus, the after-tax cash flow is $21,575 = $6,279 + $18,700 - $3,404
Financing costs are not deducted in arriving to NOI (Net OPERATING Income): NOI=Revenue - Insurance-Taxes-Utilities-Maintenance-Repairs- Vacancy - Collection costs, the formula depends on what type of asset you have, From NOI deduct depreciation and only interest expense because interest expense is tax deductible (principal repayment is not), apply taxes and you get the after tax net income. To get the cash flow (which is a sort of free cash flow) add back depreciation, and deduct the principal repayment, and end up with the cash flow.