Now that we know we are spreading the 5,000 dollar charge over the 3 years, we will rewrite the last table we had:

Our total profit then becomes: $5,000*3-$1,000*3= $12,000. We got a total of $3,000 from the tax shield!

Salvage Value

What happens when we have salvage value? Let’s first plot the difference in depreciation if we had a $3,000 salvage value.

import matplotlib.pyplot as plt
values,periods = depreciationFull(15000,0,3)
plt.plot(periods,values)
values,periods = depreciationFull(15000,3000,3)
plt.plot(periods,values)
plt.xlabel("Year")
plt.ylabel("Equipment Value")
plt.title("Straight Line Depreciation")
plt.legend(["Equipment 1","Equipment 2"])
plt.show()

The slope is less steep when the equipment has salvage value, and also it has that salvage value instead of 0 at the end of the lifetime. How would this play out for our tax shield? The tax shield would be less because our depreciation is lower, but now you get 3,000 at the end of the period from selling your equipment.

I have been simplifying this a little too much so I now want to explain the difference in accounting versus finance for depreciation. For finance, you are paying for the equipment at time 0, and getting the equipment’s salvage value at time 3. For accounting, you are able to spread the cost over time, which leads to the difference. Let’s see how it is different.

With 0 salvage value:

With 3,000 salvage value:

The way the tax shield works is as a function of the accounting charge. The actual equation is:

So let’s change the accounting column to be the tax shield

With 0 salvage value:

With 3,000 salvage value:

As you can see both salvage value of the machine, and the tax shield lower the real cost of using equipment. Also important for this, is that the salvage value is not taxed, given the condition that you actually do sell it for that much. If you do not, then you need to write either a gain (if you sell for more) or a loss (if you sell for less). If you get a gain or loss you pay a tax on the gain or get a tax credit on the loss.

Thus the cash flow from selling the equipment is:

Source Code