CMA Study Group

The company would have to commit $24,000 of working capital in addition to an immediate outlay of $160,000 for new equipment. The project is expected to generate $100,000 of annual income for 10 years. At the end of that time, the new equipment, which will be depreciated on a straight-line basis, is expected to have a salvage value of $10,000.

The existing equipment that would be sold to make room for the project has a historical cost of $220,000 and accumulated depreciation of $208,000. It has an estimated remaining useful life of 2 years and the remaining carrying amount is being depreciated on a straight-line basis. A scrap dealer has agreed to buy it for $8,000.

The company's effective tax rate is 40%.

A. 6400
B. 10000
C. 4000
D. 2400

Answer (C) is correct.
The new equipment ($160,000 historical cost) has an estimated 10-year useful life, so annual depreciation expense is expected to be $16,000. (NOTE: When calculating depreciation expense for the depreciation tax shield, salvage value is not deducted.) The old equipment has a book value of $12,000 ($220,000 historical cost – $208,000 accumulated depreciation) being depreciated on a straight-line basis over the remaining useful life of 2 years results in $6,000 depreciation expense for the next 2 years. The additional depreciation tax shield for the first year is thus the difference in the two depreciation expense amounts times the tax rate [($16,000 – $6,000) × .40 = $4,000].


My question is: can anyone explain why we deduct the old equipment depreciation from the new equipment depreciation when we calculate the depreciation tax shield?


Thanks in advance