Definition of Depreciation Tax Shield
A depreciation tax shield is the savings of the tax due to depreciation expense in the company and it is calculated as depreciation debited to profit and loss account multiplied by the applicable tax rate where the depreciation tax shield is directly related to the depreciation debited i.e., higher the depreciation debited to the profit and loss account, higher will be the tax shield.
Explanation
Depreciation is the normal wear and tear in the value of asset. It is debited to profit and loss account as expenses which reduces the profit and ultimately the tax is reduced. A depreciation tax shield is the amount of tax saved due to depreciation expense which is calculated as depreciation debited as expenses multiplied by the applicable tax rate to the entity. The depreciation is allowable to the business entity for the assets used for business and on personal assets no depreciation is allowed as expenses. Hence depreciation tax shield is only available to the business entities. For example, if the profit of the organization is $ 500,000 before depreciation and depreciation is $ 200,000 and the applicable tax rate is 20%. So, the depreciation tax shield will be $ 200,000 multiplied by 20% which is equal to $ 40,000.
How to Calculate Depreciation Tax Shield?
Calculation of Depreciation tax shield is as under:
Step 1: Calculate the amount of Depreciation to be debited to the profit and loss account. Depreciation is the normal wear and tear in the asset of the organization.
Step 2: Determine the applicable tax rate as per the prevailing tax rates.
Step 3: Calculate the Depreciation Tax Shield from the following formula:
Depreciation * Applicable Tax Rate
The resulting figure is the tax savings due to depreciation.
Examples of Depreciation Tax Shield
Following are the examples are given below:
Example #1
A Ltd has purchased the asset amounting to $ 500,000 and depreciation is on straight-line basis for 5 years i.e. depreciation per year is $ 100,000. The profit of the organization is $ 700,000. Calculate the depreciation tax shield and the net operating profit. The applicable tax rate is 20%.
Solution:
Depreciation Tax Shield is calculated as:
Depreciation Tax Shield = Depreciation * Applicable Tax Rate
- Depreciation Tax Shield =$100,000 * 20%
- Depreciation Tax Shield = $20,000
Operating Profit is calculated as:
Operating Profit = Profit – Depreciation + Depreciation Tax Shield
- Operating Profit = 700,000 – 100,000 + 20,000
- Operating Profit = $620,000
Example #2
An Ltd purchased the asset for $ 40,000 and 100% depreciation is allowed in the same year. The organization has the option to use the asset by leasing of the asset and lease rentals being $ 50,000. The net cash in the hands of the organization before the transaction is $ 70,000 to calculate which option is better for better management of cash in the current year? The tax Rate is 20%
Solution:
Net Cash from Purchase Option is calculated as
Net Cash from Purchase Option = Net Cash Before Transaction – Purchase Price of Asset + (depreciation * Tax Rate)
- Net Cash from Purchase Option = 70,000 – 40,000 + (40,000 * 20%)
- Net Cash from Purchase Option = $38,000
Net Cash from the Lease Option is calculated as
Net Cash from the Lease Option = Net Cash Before Transaction – Lease Rent + Tax Shield for Lease Payment
- Net Cash from the Lease Option = 70,000 – 50,000 + (50,000* 20%)
- Net Cash from the Lease Option = $30,000
The cash is better managed with the purchase option due to depreciation being a non-cash expenditure
Depreciation Tax Shield in Capital Budgeting
In capital budgeting, cost of the project is calculated and the best project is to be determined with the lowest cost. Depreciation is a non-cash expense and only depreciation tax shield is to be reduced from the operating profit. Through capital budgeting, it is to be determined whether it is beneficial to purchase the asset or to go for rent or lease of the asset.
For example:
The operating profit of the organization i.e. before depreciation is $ 500,000, , $ 300,000, $ 400,000, $ 250,000, $ 350,000. The depreciation per year is $ 100,000.
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The organization has two options, either to purchase the asset costing $ 500,000 by taking loan on simple interest from the bank @7% Or to lease the asset for lease rent of $ 100,000 per year for 5 years. The applicable tax rate is 20%.
Calculate which option is better?
Solution:
Interest Calculation per Year = Loan * Interest Rate
- = $500,000 * 7%
- = $35000
Depreciation per year will be $ 100,000
Depreciation tax shield per year will be $ 100,000 * 20% = $20,000
Statement of Net Cash Inflow in Case of Loan
|
Year |
Operating Profit | Interest | Interest Tax Shield | Depreciation Tax Shield |
Net Inflow |
| 1 | 500,000 | 35,000 | 7,000 | 20,000 | 452,000 |
| 2 | 300,000 | 35,000 | 7,000 | 20,000 | 252,000 |
| 3 | 400,000 | 35,000 | 7,000 | 20,000 | 352,000 |
| 4 | 250,000 | 35,000 | 7,000 | 20,000 | 202,000 |
| 5 | 350,000 | 35,000 | 7,000 | 20,000 | 302,000 |
| 1,560,000 |
Statement of Net Cash Inflow in Case of Lease
|
Year |
Operating Profit | Lease Rent | Tax Shield on LR |
Net Inflow |
| 1 | 500,000 | 120,000 | 24,000 | 404,000 |
| 2 | 300,000 | 120,000 | 24,000 | 204,000 |
| 3 | 400,000 | 120,000 | 24,000 | 304,000 |
| 4 | 250,000 | 120,000 | 24,000 | 154,000 |
| 5 | 350,000 | 120,000 | 24,000 | 254,000 |
| 1,320,000 |
Option 1 will be the better as tax can be saved more and net inflow can be improved. Hence, we can see from the above example due to the depreciation tax shield the operating inflow is to be better managed.
Importance of Depreciation Tax Shield
The importance of depreciation tax shield is explained as under:
- Tax payments can be saved due to a depreciation tax shield.
- Cash flows are to be better managed.
- It is helpful in tax planning and selecting the appropriate project.
- The benefits of the depreciation tax shield can be used for tax planning purposes.
- Plays a vital role in capital budgeting for the selection of the appropriate project.
Advantages of Depreciation Tax Shield
Some of the advantages are:
- With a depreciation tax shield, the tax expenses can be better managed.
- It is a useful tool for reducing the tax legally.
- The net cash profits can be increased as depreciation is a non-cash expense.
- Inversely related with the tax payments i.e. higher the depreciation lower the taxes.
- It is helpful in tax planning and deciding whether to purchase the asset and avail of a depreciation tax shield or to lease the asset.
Conclusion
A depreciation tax shield is one of the measures through which tax is to be reduced. It is inversely related with the tax payments higher the depreciation tax shield lower will be the depreciation. Depreciation is the non-cash expense hence with the proper planning the net operating cash flows can be increased and better management of funds are to be done. In capital budgeting also it is one of the useful tools to decide whether to purchase the asset or to lease the asset. Tax payments can be better managed with the depreciation tax shield.
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