CMA Study Group

Depreciation Tax Shield

  • 1.  Depreciation Tax Shield

    Posted 17 days ago
    The company would have to commit $24,000 of working capital in addition to an immediate outlay of $160,000 for new equipment. The project is expected to generate $100,000 of annual income for 10 years. At the end of that time, the new equipment, which will be depreciated on a straight-line basis, is expected to have a salvage value of $10,000.
    The existing equipment that would be sold to make room for the project has a historical cost of $220,000 and accumulated depreciation of $208,000. It has an estimated remaining useful life of 2 years and the remaining carrying amount is being depreciated on a straight-line basis. A scrap dealer has agreed to buy it for $8,000.
    The company's effective tax rate is 40%.
     
    What is the expected additional depreciation tax shield for the first year of the project is?

    A. $6,400 B. $4,000 C. $2,400 D. $0

    I am confused - I know the dep tax shield of the new Machine for year one is 6400 and the old machine for year one is 2400. But what is the meaning of "Additional dep tax shield"? The correct answer is 4000. Can anyone explain how?



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    Nupur Mahajan
    None
    Hartford CT
    United States
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  • 2.  RE: Depreciation Tax Shield

    Posted 16 days ago
    The additional depreciation tax shield would be $3,600.

    Before the new project, the old equipment has a carrying value of $12,000 (historical cost 220k - accumulated depreciation 208k = 12k).  It has a remaining useful life of 2 years and on a straight-line depreciation basis, would be depreciated $6,000/year.  At a 40% tax rate, this gives a depreciation tax shield of 6000*0.40 = $2,400.

    The new equipment has an initial cost of $160,000 and an expected salvage value of $10,000 so the total amount you can depreciate is $150,000.  Straight-line depreciation over a 10 year useful life would be $15,000 annual depreciation.  At a 40% tax rate, this gives a depreciation tax shield of $6,000.

    You would sell the old equipment, so you won't get that deprecation tax shield.  Instead of a depreciation tax shield of $2,400, you'd only have a depreciation tax shield of $6,000.  If you take the new amount $6,000 less the old amount $2,400, you have an additional depreciation tax shield of $3,600.

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    Michelle Burke
    Student
    Plaistow NH
    United States
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  • 3.  RE: Depreciation Tax Shield

    Posted 16 days ago
    Hey, thank you so much. I get it why the depreciation tax shield of old asset was deducted. It is the cash inflow "loss" as I have let go of the old equipment.

    I would like to highlight here is that the Depreciation tax shield of the new asset will be 6400$ because the tax shield is calculated at 100% of the asset's value and salvage value will not be deducted. Hence, $6400. So additional dep tax shield is $6400-@2400=$4000.

    Thank you so much for your reply.


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    Nupur Mahajan
    Ex-Deloitte, Sutherland and Moody's
    Hartford CT
    United States
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  • 4.  RE: Depreciation Tax Shield

    Posted 15 days ago
    I would have to disagree with that because the depreciable amount is the carrying value less the salvage value.

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    Michelle Burke
    Student
    Plaistow NH
    United States
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  • 5.  RE: Depreciation Tax Shield

    Posted 15 days ago
    Well, the notes in Gleim and Hock says not to subtract the salvage value. Anyway, $3400 is not in the option.

    Sent from my iPhone XS




  • 6.  RE: Depreciation Tax Shield

    Posted 10 days ago
    Hi All,

    There are two standards here.

    Depreciations for preparation of balance sheet is done using the salvage value (depending on the depreciation method); this is approved by GAAP.

    Depreciations for tax purposes is done with the Modified Accelerated Cost Recovery System (MACRS) depreciation method; and for this method, salvage value is NOT considered. This method is not approved by GAAP.

    In summary, for tax purposes, salvage value is disregarded; even if the MACRS method is replaced by straight-line depreciation method for ease of calculation during the exam.

    Hope this clarifies.
    Regards,

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    Felix Lawson
    Finance Officer
    Kenya
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  • 7.  RE: Depreciation Tax Shield

    Posted 10 days ago
    Yes, totally. I agree with Late Lawson. I read this in Hock. While depreciation for financial purposes need salvage value to be deducted, it is not the case in depreciation for tax purposes. Thank you for a clear and crisp answer.

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    Nupur Mahajan
    nupur1188@...
    Hartford CT United States
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