Question

9. For taxation purposes the new building has a twenty-year life. However, Lovisa will perform the financial analysis of the Luddenham store over a ten-year period. The new store requires $300,000 of display cabinets. The Australian Taxation Office (ATO) confirms that display cabinets have an eight-year tax life. In Lovisa’s experience, display cabinets can be operated effectively for a full ten years before they need replacing. Lovisa’s management accountants depreciate all non-current assets over an operational six-year life.

How do you work out the tax saving and tax effect of the following scenario for a capital budgeting report?

Answer 1

Depreciation is a non-cash item of expense charged in the Income statement , legally allowed to be amortised over the economically useful life-years of the asset, ie. An allocation of the original capital expense --charged to revenue , at a fixed but consistent rate.

This depreciating rate can be different from what is allowed under the country's federal tax laws, but they need to be consistent & if at all needs to be changed, should be adequately disclosed , with all its effects, on profits & earnings to owners , explicitly stated, in the published financial statements.

Even if the yearly depreciation differs from that allowed under Taxation Office rules,the difference in tax on income (due to different amounts of depreciation) is called temporary tax difference, which will be evened out , over time, ie. No.of years. It is only a matter of time, before full depreciation amount is allowed as chargeable expense by the taxation authorities.Only issue, will be the time value of the money involved. The later , you get, the lesser its value.

In contrast,

for capital budgeting, we consider depreciation , only for its tax-shield effect, ie. The cash(tax) savings contributed by the depreciation charge against the profits of any profit.

Depreciation tax savings= Depreciation amount*Tax rate

Practically, cash outflow saved due to depreciation- tax shield is considered only on allowable expense as per tax authorities---which, in turn, is, what is acceptable to them or allowed as per tax-laws.

As capital budgeting is all about cash flows --inflows, outflows, inflows cannibalised or outflows saved ---it is only prudent we consider depreciation as allowed under the Australian Taxation Office (ATO) that confirms that display cabinets have an eight-year tax life--- and base our workings on that.

As this is not accrual acounting , as said , in the initial paras.

So, it is $ 300000/8 yrs. =$ 37500 annual depreciation for the first 8 years of the project , even ,if the project is for 10 years.

and the tax shield in each of the 8 yrs. Will be 37500*Tax rate%---which will be discounted along with other cash flows , at the appropriate discount rate.