The increase in cash flow generated as a result of a firm’s tax-deductible depreciation expense is called the:
The correct answer and explanation is:
The correct answer is Depreciation Tax Shield.
Depreciation tax shield refers to the reduction in taxable income a company experiences due to its ability to deduct depreciation expenses from its earnings. This deduction reduces the taxable income, thus lowering the amount of taxes the company has to pay, which increases its cash flow.
Depreciation is a non-cash expense, meaning that while it reduces the company’s accounting profit, it does not directly impact the actual cash flow. However, since depreciation is tax-deductible, it lowers the tax liability of the company. As a result, the firm retains more cash that would have otherwise been paid out as taxes.
For instance, if a company purchases a new asset, such as machinery, it can spread the cost of that asset over its useful life through depreciation. The annual depreciation expense reduces the company’s reported taxable income. The company will then pay less in taxes, which, in turn, increases its cash flow.
The depreciation tax shield is calculated by multiplying the depreciation expense by the company’s tax rate. For example, if a company has a depreciation expense of $50,000 and is subject to a tax rate of 30%, the depreciation tax shield would be $15,000. This means the company would save $15,000 in taxes due to the depreciation expense, thus increasing its available cash flow.
This tax shield is valuable because it allows companies to improve their liquidity without needing to make changes to their operations. By using depreciation to reduce taxable income, companies can reinvest this saved capital into growth opportunities, pay down debt, or cover operating expenses.