How to Calculate Tax Amortization Benefit
A tax amortization benefit is the cash flow generated from an asset as a result of being able to write off the full fair value of the asset for tax purposes. This benefit can affect the fair value of an asset by as much as 20 to 30 percent. For example, assume you have an asset worth $400 that will produce $10 a year for a period of 10 years with a useful life of 10 years.
Determine the discount rate (Dr). This is generally the market interest rate. For example, Dr equals 10 percent.
Discount all projected cash flows from the asset using the discount rate of 10 percent and apply the PVCF formula to work out the present value of cash flows from the asset. This is: PVCF = Payment Value ((1-(1/(1+Dr)^Number of Periods))/Dr).
For example: PVCF = $10 ((1-(1/(1+.10)^10)) / .10. Therefore, PVCF = $61.45.
Identify the amortization period (n). This is the same as the useful life of the asset. In this example, n equals 10 years.
Identify the applicable tax rate (T). For example, T equals 30 percent.
Calculate the present value of an annuity of $1 (PVA) over the amortization period, at the discount rate. Use the following formula: PVA = $1 ((1-(1/(1+Dr)^n))/Dr).
For example, PVA = $1 ((1-(1/(1+.10)^10))/.10). Therefore, PVA = $6.14.
Calculate the tax amortization benefit (AB) using the following formula: AB = PVCF * (n/(n-(PVA_T))-1). For example, AB = 61.45 * (10/(10-(6.14_.30))-1). Therefore, AB = $85.85.
Tip
Account for tax amortization benefits when determining the fair value of an asset, as benefits can be significantly large for valuable assets that produce large amounts of cash flow.
Warning
If you don't take into account tax amortization benefits when determining fair value, you may violate the matching principle by recording deferred tax liabilities.