What is the Depreciation Tax Shield?
The Depreciation Tax Shield refers to the reduction in taxable income due to depreciation expenses, leading to tax savings for a company.
Since depreciation lowers a company’s earnings before taxes (EBT) on the income statement, it also decreases the total tax liability for financial reporting purposes.
DTS= Depreciation expense × Tax rate
How Does the Depreciation Tax Shield Work?
Under U.S. GAAP, depreciation allocates the cost of a company’s property, plant, and equipment (PP&E) over its useful life.
Depreciation is an accounting method that aligns the recognition of capital expenditures (CapEx) with the revenue generated by those assets over time. Even though the company has already incurred the cash outflow when purchasing the fixed assets, the expense is distributed across multiple periods in financial statements. This allocation of costs can also help businesses file taxes more efficiently by reducing taxable income, which can lower their overall tax liability for each period.
By reducing pre-tax income (EBT), depreciation creates a tax advantage known as the “depreciation tax shield,” effectively lowering the company’s tax obligation.
How to Calculate the Depreciation Tax Shield
Determine the depreciation tax shield, the first step is identifying the company’s depreciation expense.
Depreciation and amortization (D&A) costs are included in the cost of goods sold (COGS) and operating expenses. The most reliable source for the total depreciation value is the cash flow statement (CFS).
Once located, the next step is to isolate the depreciation component, which may be combined with amortization. Public companies report these figures in SEC filings, while private firms may require direct inquiries to management for precise data.
Finally, the depreciation expense is multiplied by the applicable tax rate to compute the tax shield.
Depreciation Tax Shield Formula
To determine the Depreciation Tax Shield is:
DTS= Depreciation expense × Tax rate(%)
If necessary, annual depreciation can be manually estimated by subtracting the salvage value (the remaining asset value at the end of its life) from the purchase price and then dividing it by the asset’s useful life.
Since depreciation is a non-cash expense, it is added to the net income in the cash flow statement (CFS), improving free cash flows (FCFs). This can enhance the company’s valuation by increasing its available cash.
Depreciation Tax Shield: Calculation and Example
A company has two scenarios, A and B, where the only difference is depreciation.
- Revenue: $20M
- COGS: $6M
- SG&A: $4M
- Tax Rate: 20%
Scenario A (No Depreciation)
- EBIT = $10M
- Taxes = $2M
- Net Income = $8M
Scenario B (With $2M Depreciation)
- EBIT = $8M
- Taxes = $1.6M
- Net Income = $6.4M
The tax savings from depreciation is $400K, called the depreciation tax shield. The depreciation tax shield is the tax savings a company gets from depreciation. In this example, depreciation reduces taxable income, lowering taxes from $2M to $1.6M, saving $400K in taxes.
