Question

1. In most cases you would think you do not even bother to calculate taxes if you have no income or a loss; why would you subtract a negative tax amount (tax rate times income loss is a negative number) in certain cases?

1. B.Explain what a depreciation tax shield is?

Answer 1

1. In most cases you would think you do not even bother to calculate taxes if you have no income or a loss; why would you subtract a negative tax amount (tax rate times income loss is a negative number) in certain cases?

A loss creates a tax shield equivalent to the tax rate times the loss.

It is a tax shield, as it can be set off against the tax payable on the profits of other activites that the same entity has in the same year or it can be carried forward and set off against the tax payable on the profits of the same activity in future years.

Hence, losses are relevant as they provide benefits in the form of tax shield.

B. Explain what a depreciation tax shield is?

Depreciation is a non cash expense as it does not entail a cash outflow. But it is a tax deductible expense, which means that the taxable income can be arrived at after deducting the applicable depreciation. Hence, it provides a reduction in the tax payable equivalent to the depreciation expense times the tax rate. It is thus a cash inflow.

The benefit in the form of lower taxes that the depreciation affords is called depreciation tax shield.