An Explanation of the Depreciation Tax Shield
When a business buys an asset, such as a building or vehicle, the cost of the asset is generally not a tax deduction as an expense but rather must be depreciated over a number of years. The amount of the depreciation then becomes a tax-deductible expense each year, lowering the taxable income and thus the amount of taxes owed. This reduction in taxes is called the depreciation tax shield.
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Example
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Let's say a business has $100,000 in revenue and $50,000 in operating expenses, meaning the business has a taxable income of $50,000. At a tax rate of 30 percent, the taxes owed are $15,000. However, if that same business also owns a depreciable asset that that provides a $20,000 depreciation deduction, the taxable income is now $30,000 and the taxes owed are $9,000. The depreciation tax shield is $6,000.
Expense vs. Tax Shield
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The depreciation tax shield is different from the depreciation expense recorded in accounting records and reported for tax purposes. In the example, the depreciation expense is $20,000. The tax shield of $6,000 just represents a tax savings.
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Effect on Cash Flow
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Depreciation is a tax expense and not a direct cash flow, meaning that capital budgeting decisions involving discounted cash flow computations ignore depreciation. However, because depreciation affects taxes through the depreciation tax shield, it has an indirect effect that does affect after-tax cash flows.
Considerations
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A business will consider the effect of the depreciation tax shield when deciding whether to buy or lease equipment or other assets, because leased assets do not create a depreciation tax shield. Of course, other factors come into play in this decision, such as interest rates to finance assets and how long the business plans to keep the assets.
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