Tax shield
Encyclopedia
A tax shield is the reduction in income tax
es 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
.
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.
. Under this assumption, the value of the tax shield is: (interest bearing debt) x (tax rate).
Using the above examples:
Income tax
An income tax is a tax levied on the income of individuals or businesses . Various income tax systems exist, with varying degrees of tax incidence. Income taxation can be progressive, proportional, or regressive. When the tax is levied on the income of companies, it is often called a corporate...
es that results from taking an allowable deduction
Itemized deduction
An itemized deduction is an eligible expense that individual taxpayers in the United States can report on their federal income tax returns in order to decrease their taxable income....
from taxable income
Taxable income
Taxable income refers to the base upon which an income tax system imposes tax. Generally, it includes some or all items of income and is reduced by expenses and other deductions. The amounts included as income, expenses, and other deductions vary by country or system. Many systems provide that...
. For example, because interest on debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
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
Business valuation
Business valuation is a process and a set of procedures used to estimate the economic value of an owner’s interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to consummate a sale of a business...
.
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 foreverGoing concern
A going concern is a business that functions without the threat of liquidation for the foreseeable future, usually regarded as at least within 12 months.-Definition of the 'going concern' concept:...
. 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 tax shield: $1,800 – $1,000 = $800
- Alternatively, debt x tax rate: $4,000 x 20% = $800;