Introduction to Finance

TA B L E 1 7 . 7
JohnnyJim Products Income Statements, With and Without 
Depreciation Expense
With Depreciation 
Expense
Without Depreciation 
Expense
Sales
$1000
$1000
–Costs
–300
–300
–Depreciation
–100
0
EBT
$600
$700
–Taxes (40%)
240
280
Net Income
$360
$420

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546
C H A PT E R 1 7 Capital Budgeting Analysis
earnings before taxes, noncash depreciation expense lowers a cash expense; that is, taxes, are 
lower by $40. This $40 reduction leads to an operating cash fl ow that is $40 higher than the 
example using no depreciation.
The $40 savings in taxes arises from a combination of the tax rate, 
T
, and the depreciation 
expense. With a 40 percent tax rate, a depreciation expense of $100 increases expenses and 
lowers taxes by (0.40)($100), or $40. 
This term, (
T
)(Depreciation), the tax rate multiplied by the depreciation expense, is called 
the 
depreciation tax shield
. It represents the tax savings the fi rm receives from its noncash 
depreciation expense. With a 40 percent tax rate, a depreciation expense of $100 reduces a 
fi rm’s tax bill by $40. 
Despite political claims that tax incentives are needed to boost capital spending and 
investment, a healthy economy can do more for capital investment than the most generous 
politicians. The United States enjoyed a capital spending boom in the 1990s despite doing 
without favorable tax law changes, investment tax credits, or changes in depreciation rules. 
A good economy with sustained growth and low infl ation is the best combination for corpor-
ate investment. As one corporate executive said, “We’re not sitting on our hands waiting for 
government tax policy to change. If you want to protect and extend your market position, you 
invest the money. We would do that no matter what.”
Economists do favor incentives, such as a capital gains tax cut, that would increase sav-
ings in the economy. Greater savings, all else being constant, would mean lower interest rates, 
higher stock prices, and lower fi nancing costs for fi rms buying plant and equipment.
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