Explain tax and depreciation

Tax

Tax is a compulsory payment made by individuals and firms to the government, used to finance public services. Corporate income tax is charged on taxable income:

Taxable income = Gross income − Expenses (O&M, interest) − Depreciation
Income tax     = Taxable income × tax rate
After-tax cash flow (ATCF) = Before-tax cash flow − Income tax

In engineering economy, tax is a cash outflow and must be considered because it reduces the profit of a project.

Depreciation

Depreciation is the decrease in the value of an asset over time because of wear, ageing or obsolescence. In accounting and tax it is the spreading of the cost (less salvage value) over the asset's useful life. It is a non-cash expense: no money is paid out, but it is deducted from income before tax, so it gives a tax shield equal to depreciation × tax rate.

Example

A machine costs Rs 1,00,000, salvage Rs 20,000, life 5 years, gives Rs 45,000/year before tax; tax rate 30%. SL depreciation = (1,00,000 − 20,000)/5 = 16,000 per year.

Taxable income = 45,000 − 16,000 = 29,000
Tax            = 0.30 × 29,000    = 8,700
ATCF           = 45,000 − 8,700   = 36,300 per year

Without depreciation the tax would be 0.30 × 45,000 = 13,500, so depreciation saves 16,000 × 0.30 = Rs 4,800 in tax each year. Faster depreciation (DDB, SOYD, MACRS) moves the tax saving earlier and increases the present worth of the project.