The Tax Shield Approach

The third variation on our basic definition of OCF is the tax shield approach. This approach will be very useful for some problems we consider in the next section. The tax shield definition of OCF is:

OCF = (Sales - Costs) X (1 - T) + Depreciation X T [10.3]

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

OCF = ($1,500 - 700) X .66 + 600 X .34 = $528 + 204 = $732

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 $528.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

IV. Capital Budgeting

10. Making Capital Investment Decisions

© The McGraw-Hill Companies, 2002

CHAPTER 10 Making Capital Investment Decisions

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 $600 depreciation deduction saves us $600 X .34 = $204 in taxes.

For the shark attractant project we considered earlier in the chapter, the depreciation tax shield would be $30,000 X .34 = $10,200. The aftertax value for sales less costs would be ($200,000 - 137,000) X (1 - .34) = $41,580. Adding these together yields the value of OCF:

This calculation verifies that the tax shield approach is completely equivalent to the approach we used before.

depreciation tax shield

The tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate.

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