Exercise-18: Tax savings from depreciation tax shield

Learning objective:
This exercise illustrates the computation of tax saving caused by recording the annual depreciation expense. This saving is generally referred to as depreciation tax shield.

Exercise-18 (a):

Marshal Company has just purchased an asset costing $420,000. The straight line method of depreciation will be used and the entire cost of the asset will be depreciated over 6 years. The tax rate of Marshal Company is 30%.

Required:

Calculate annual tax savings from depreciation tax shield.

Solution:

The annual depreciation would be computed first and then multiplied by 30% or 0.30 to find the annual tax savings from depreciation tax shield.

Annual depreciation = $420,000/6 years
= $70,000

Annual tax savings from depreciation tax shield = Annual depreciation × Tax rate
= $70,000 × 0.30
= $21,000

Marshal will save $21,000 tax per year on account of its annual depreciation expense.

Exercise-18 (b):

Robin Inc. avails an annual depreciation tax shield of $2,000 on account of its 500kw diesel engine electricity generator. The generator has a useful economic life of 20 years and is depreciated using a straight-line method. Robin’s tax rate is 25%. (Ignore installation costs and salvage value).

Required:

1. Calculate annual depreciation charge on the electricity generator.
2. Calculate the original cost of the generator.

Solution:

(1). Annual depreciation charge:

The annual depreciation tax shield and the income tax rate are given in the question. So, we can compute the annual depreciation charge by simply dividing the amount of tax shield by the tax rate.

Annual depreciation charge = Depreciation tax shield/Tax rate
Annual depreciation = $2,000/0.25
= $8,000

(2). Original cost of the generator:

Since the engine is depreciated using a straight line method, we can compute its original cost by multiplying the annual depreciation charge by the years of useful life.

Original cost of engine = Annual depreciation × Years of useful life
= $8,000 × 20
= $16,000