Updated July 17, 2023
Definition
A depreciation tax shield is the tax savings from the company’s depreciation expense. It calculates as depreciation debited to the profit and loss account multiplied by the applicable tax rate where it is directly related to the depreciation debited, i.e., the higher the depreciation debited to the profit and loss account, the higher will be the tax shield.
Explanation
Depreciation is the normal wear and tear in the value of the asset. It is debited to the profit and loss account as expenses, reducing the profit and tax. It is the amount of tax saved due to depreciation expense which calculates as depreciation debited as expenses multiplied by the applicable tax rate to the entity. Depreciation is allowable to the business entity for the assets used for business, and on personal investments, no depreciation is allowed as expenses. Hence this is only available to business entities. For example, if the organization’s profit is $ 500,000 before depreciation and depreciation is $ 200,000, and the applicable tax rate is 20%. So, it will be $ 200,000 multiplied by 20%, which equals $ 40,000.
How to Calculate Depreciation Tax Shield?
The calculation 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 per the prevailing tax rates.
Step 3: Calculate the Depreciation Tax Shield from the following formula:
The resulting figure is the tax savings due to depreciation.
Examples
Following are the examples are below:
Example #1
An Ltd has purchased the asset amounting to $ 500,000, and depreciation is on a 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:
It calculates as:
- Depreciation Tax Shield =$100,000 * 20%
- Depreciation Tax Shield = $20,000
Operating Profit calculates as follows:
- 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 can use the asset by leasing the lease rentals of $ 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 cash management in the current year? The tax Rate is 20%
Solution:
Net Cash from the Purchase Option calculate as
- 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 calculates as
- 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
Capital budgeting calculates the project’s cost; the best project determines the lowest cost. Depreciation is a non-cash expense; only the depreciation tax shield will be reduced from the operating profit. Capital budgeting determines whether it is beneficial to purchase the asset, go for rent, or lease the asset.
For Example:
The organization’s operating profit, i.e., before depreciation, is $ 500,000, $ 300,000, $ 400,000, $ 250,000, and $ 350,000. The depreciation per year is $ 100,000.
The organization has two options: purchase the asset costing $ 500,000 by taking a loan on simple interest from the bank @7% Or 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
The 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 better as tax can be saved more and net inflow can be improved. Hence, we can see from the above example that the operating inflow is to be better managed due to the depreciation tax shield.
Importance
The importance 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 it can be used for tax planning purposes.
- It plays a vital role in capital budgeting for selecting the appropriate project.
Advantages
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 to 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 lease the asset.
Conclusion
It is one of the measures through which tax is to be reduced. It is inversely related to the tax payments higher the depreciation tax shield lower will be the depreciation. Depreciation is a non-cash expense; hence, the net operating cash flows can be increased with proper planning, and better funds management will be done. Capital budgeting is also useful for deciding whether to purchase or lease the asset. Tax payments can be better managed with it.
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