The Tax Shield Approach

depreciation tax shield

The tax saving thai results from the depreciation deduction, calcuiated as depreciation multiplied by the corporate tax rate.

A useful variation on our basic definition of operating cash flow (OCF) is the tax shield approach. The tax shield definition of OCF is:

where T is the coiporate tax rate. Assuming that T = 34%. the OCF works out to be:

OCF = {$200,000 - 137,000] x .66 + 30,000 x .34 = $41,580 + 10,200 = $51,780

This is just as we had before.

This approach views OCF as having two components. The first part is what the project's cash flow would be if there were no depreciation expense. In this case, this would-have-been cash flow is $41,580.

The second part of OCF in this approach is the depreciation deduction multiplied by the tax rate. This is called the depreciation tax shield. We know that depreciation is a noncash expense. The only cash flow effect of deducting depreciation is to reduce our taxes, a benefit to us. At the current 34 percent corporate tax rate, every dollar in depreciation expense saves us 34 cents in taxes. So. in our example, the $30.000 depreciation deduction saves us $30.000 x .34 = $10.200 in taxes.

The tax shield approach will always give the same answer as our basic approach, so you might wonder why we bother. The answer is that it is sometimes a little simpler to use, particularly for projects that involve cost-cutting.

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