Question

Bright Horizons Skilled Nursing Facility, an investor owned company, constructed a new building to replace its outdated facility. The new building was completed on Jan 1, 2015, and Bright Horizons began recording depreciation immediately. The total cost of the new facility was $18,000,000, comprising (a) $10 million in construction costs and (b) $8 million for the land. Bright Horizons estimated that the new facility would have a useful life of 20 years. The salvage value of the building at the end of its useful life was estimated to be $1,500,000.

1. Using the straight line method of depreciation, calculate annual depreciation expense on the new facility.
2. Assuming a 40 percent income tax rate, how much did Bright Horizons save in income taxes for the year ended December 31, 2015, as a result of the depreciation recorded on the new facility (i.e., what was the depreciation shield?
3. Does the depreciation shield result in cash or non cash savings for Bright Horizons? Explain.

Answer 1

1-
Annual Depreciation
Construction cost of building		10000000
less scrap value of		1500000
value of construction cost to be depreciated		8500000
Annual depreciation-Using straight line method	value of construction cost to be depreciated/life of building	8500000/20	425000
2-
Depreciation tax shield	annual depreciation*tax rate	425000*40%	170000
3-
The depreciation will represent cash savings because while depreciation is listed as an expense on the income statement, it is not actually paid out so saving of income tax on on that part of their income which is saved due to depreciation expense