---
title: "Explain tax and depreciation"
subject: "Engineering Economics"
chapter: 7
key: "semester_6/engineering_economics:explain-tax-and-depreciation"
source: https://www.bctengineer.com/q/semester_6/engineering_economics/explain-tax-and-depreciation
site: BCT Engineering
---

# Explain tax and depreciation

Engineering Economics · Chapter 7: Depreciation and Corporate Income Taxes

- Asked in: 2066 Magh, 4 marks; 2065 Kartik, 4 marks (asked 2 times)
- Answer checked by Claude Opus 5.5 (high effort) on 2026-10-14
- Page: https://www.bctengineer.com/q/semester_6/engineering_economics/explain-tax-and-depreciation
- Whole chapter: https://www.bctengineer.com/md/semester_6/engineering_economics/chapter-7

## Question

Explain tax and depreciation with suitable examples.

## Short answer

Tax is levied on taxable income (gross income minus expenses and depreciation). Depreciation is a non-cash expense that creates a tax shield equal to depreciation × tax rate. Example: SL depreciation of Rs 16,000//year on a Rs1,00,000 machine at 30% tax saves Rs4,800//year in taxes.

## Answer

#### 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**:
```text
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.
```text
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.

## Check yourself

The answer's key points as multiple-choice questions, with the correct option and why.

1. How is taxable income found?
   A. Gross income - expenses - depreciation
   B. Gross income - expenses + depreciation
   C. Gross income - tax
   D. Gross income - salvage value
   Answer: A. Depreciation is deductible, so it reduces taxable income. (Key point: Taxable income)

2. Why does depreciation affect cash flow though no money is paid?
   A. It is a real cash outflow each year
   B. It reduces taxable income, giving a tax shield of depreciation x tax rate
   C. It increases gross income
   D. It is added back to the salvage value
   Answer: B. The tax saved is cash retained by the firm. (Key point: Non-cash expense and tax shield)

3. Machine Rs 1,00,000, salvage 20,000, life 5, benefit 45,000, tax 30%, SL. What is the yearly ATCF?
   A. Rs 31,500
   B. Rs 45,000
   C. Rs 36,300
   D. Rs 29,000
   Answer: C. Depreciation 16,000; taxable income 29,000; tax 8,700; ATCF = 45,000 - 8,700 = 36,300. (Key point: Example ATCF)

4. How much tax does depreciation save in the example?
   A. Rs 16,000 per year
   B. Rs 8,700 per year
   C. Rs 13,500 per year
   D. Rs 4,800 per year
   Answer: D. 16,000 x 0.30 = 4,800 (tax would be 13,500 without it versus 8,700). (Key point: Tax saving)

## Related in Engineering Economics

- [After-tax cash flow, sinking fund depreciation](https://www.bctengineer.com/question.md?key=semester_6%2Fengineering_economics%3Aaftertax-cash-flow-sinking-fund-25000) — Engineering Economics, chapter 7
- [PW and IRR after tax with SL depreciation](https://www.bctengineer.com/question.md?key=semester_6%2Fengineering_economics%3Apw-irr-sl-tax-20-million) — Engineering Economics, chapter 7
- [After-tax cash flow, DDB with switchover](https://www.bctengineer.com/question.md?key=semester_6%2Fengineering_economics%3Aafter-tax-cash-flow-ddb-switchover) — Engineering Economics, chapter 7
- [MACRS schedule and after-tax IRR by AW](https://www.bctengineer.com/question.md?key=semester_6%2Fengineering_economics%3Amacrs-after-tax-irr-aw-45000) — Engineering Economics, chapter 7
- [ATCF and IRR with given depreciation schedule](https://www.bctengineer.com/question.md?key=semester_6%2Fengineering_economics%3Aatcf-irr-pw-macrs-style-1000000) — Engineering Economics, chapter 7