Question

3.8 Bright Horizons Skilled Nursing Facility, an investor-owned company, constructed a new building to replace its outdated facility. The new building was completed on January 1, 2015, and Bright Horizons began recording depreciation immediately. The total cost of the new facility was $18,000,000, comprising (a) $10 million in construction costs and (b) $8 million for the land. Bright Horizons estimated that the new facility would have a useful life of 20 years. The salvage value of the building at the end of its useful life was estimated to be $1,500,000. a. Using the straight-line method of depreciation, calculate annual depreciation expense on the new facility b.Assuming a 40 percent income tax rate, how much did Bright Horizons save in income taxes for the year ended December 31, 2015, as a result of the depreciation recorded on the new facility (i.e., what was the depreciation shield)? c.Does the depreciation shield result in cash or noncash savings for Bright Horizons? Explain.

Answer 1

Answer : (a.) Calculation of Annual depreciation expense on the new facility :

Cost of Construction = $ 10,000,000

Cost of Land = $8,000,000

Note : Since Land is non depreciable assets no depreciation will be charged on Land sice cost of Buildong and cost of Constructions is given separately , we will charge depreciation only on Building)

Annual Depreciation Expense = (Cost of Construction - Salvage Value) / Number of years of useful Life

= (10,000,000 - 1,500,000) / 20

= $ 425,000

(b.) Calculation of saving in income taxes for the year ended December 31, 2015, as a result of the depreciation recorded on the new facility (i.e. depreciation shield)

Depreciation Shield = Depreciation Expense * Tax Rate

= 425,000 * 0.40

= 170,000

(c.)  Depreciation shield result in cash savings for Bright Horizons as depreciation is non cash item which is an expense for the organization butorganisation don't have to pay taxes on that part of income as depreciation being expenses saves Tax . Saving of Tax is as good as Cash Saving becuse there will be lesser outflow of tax due to depreciation . Therefore Depreciation shield result in cash savings.