Problem Depreciation as a Tax Shield
The term tax shield refers to the amount of income tax saved by deducting depreciation for income tax purposes. Assume that Rummy Company is considering the purchase of an asset as of January 1, 2014. The cost of the asset with a five-year life and zero residual value is $60,000. The company will use the double-declining-balance method of depreciation.
Rummy's income for tax purposes before recording depreciation on the asset will be $62,000 per year for the next five years. The corporation is currently in the 30% tax bracket.
Required
Calculate the amount of income tax that Rummy must pay each year if (a) the asset is not pur- chased and (b) the asset is purchased. What is the amount of tax shield over the life of the asset?
What is the amount of tax shield for Rummy if it uses the straight-line method over the life of the asset? Why would Rummy choose to use the accelerated method?