Question

Depreciation as a Tax Shield

The term tax shield refers to the amount of income tax saved by deducting depreciation for income tax purposes. Assume that Supreme Company is considering the purchase of an asset as of January 1, 2017. The cost of the asset with a five-year life and zero residual value is $83,300. The company will use the straight-line method of depreciation.

Supreme's income for tax purposes before recording depreciation on the asset will be $53,100 per year for the next five years. The corporation is currently in the 30% tax bracket.

Required:

Calculate the amount of income tax that Supreme must pay each year if the asset is and is not purchased.

1. Amount of taxes paid if asset is not purchased is:	$
2a. Amount of depreciation if asset is purchased is:	$
b. Amount of taxes paid if asset is purchased is:	$
3. What is the amount of the depreciation tax shield?

Answer 1

Based on the information available in the question, we can answer as follows:-

Requirement 1:-

The amount of taxes paid if asset is not purchased is :-

$53,100 * 30% = $15,930

Amount of taxes paid = $15,930 per year.

Requirement 2a:-

Amount of depreciation if asset is purchased is :-

Depreciation per year = $83,300/5 years

Depreciation per year = $16,660 per year.

Requirement 2b:-

Amount of taxes paid if asset is purchased = $53,100 Net Income - $16,660 Depreciation expense = $36,440

Taxes paid = $36,440 * 30%

Taxes paid = $10,932 per year

Requirement 3:-

The amount of Depreciation tax shield = Depreciation expense * Tax rate

=$16,660 * 30%

Depreciation tax shield = $4,998 per year