Tax shield

A tax shield is the reduction in income taxes that results from taking an allowable deduction from taxable income. For example, because interest on debt is a tax-deductible expense, taking on debt creates a tax shield. Since a tax shield is a way to save cash flows, it increases the value of the business, and it is an important aspect of business valuation.

Example

Case A

Consider one unit of investment that costs $1,000 and returns $1,100 at the end of year 1, i.e. a 10% return on investment before taxes. Now assume tax rate of 20%. If an investor pays $1,000 of capital, at the end of the year, he will have ($1,000 return of capital, $100 income and –$20 tax) $1,080. He earned net income of $80, or 8% return on capital.

Case B

Consider the investor has an option to borrow $4000 at 8% interest (same rate as return of capital in Case A). By borrowing $4,000 in addition to the $1,000 of his initial equity capital, the investor can purchase 5 units of investment. At the end of the year, he will have: ($5,000 return of capital, –4,000 repayment of debt, $500 revenue, –$320 interest payment, and –$(500-320)*20%=–$36 tax). Therefore, he is left with $1,144. He earned net income $144, or 14.4%.

The reason that he was able to earn additional income is because the cost of equity capital (opportunity cost, 8%) is not deductible for tax purposes, but the cost of debt (interest) is.

Value of the Tax Shield

In most business valuation scenarios, it is assumed that the business will continue forever. Under this assumption, the value of the tax shield is: (interest bearing debt) x (tax rate).

Using the above examples:

• Assume Case A brings $80 after-tax income per year, forever.
• Assume Case B brings $144 after-tax income per year, forever.

• Value of firm in Case A: $80/0.08 = $1,000
• Value of firm in Case B: $144/0.08 = $1,800
• Increase in firm value due to borrowing: $1,800 – $1,000 = $800
• Alternatively, debt x tax rate: $4,000 x 20% = $800;

See also

• Adjusted present value
• Cost of capital
• Valuation (finance)

External links

• The Value of Tax Shields IS Equal to the Present Value of Tax Shields
• Tax Shield at Investopedia.com