A tax shield is the reduction in

income tax An income tax is a tax imposed on individuals or entities (taxpayers) in respect of the income or profits earned by them (commonly called taxable income). Income tax generally is computed as the product of a tax rate times the taxable income. Ta ...

es that results from taking an allowable deduction from

taxable income Taxable income refers to the base upon which an income tax system imposes tax. In other words, the income over which the government imposed tax. Generally, it includes some or all items of income and is reduced by expenses and other deductions. ...

. For example, because interest on

debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The ...

is a tax-deductible expense, taking on debt creates a tax shield. Since a tax shield is a way to save

cash flows A cash flow is a real or virtual movement of money: *a cash flow in its narrow sense is a payment (in a currency), especially from one central bank account to another; the term 'cash flow' is mostly used to describe payments that are expected ...

, it increases the value of the business, and it is an important aspect of

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. Here various valuation techniques are used by financial market participants to determine the price they are willing t ...

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. The concept was originally added to the

methodology In its most common sense, methodology is the study of research methods. However, the term can also refer to the methods themselves or to the philosophical discussion of associated background assumptions. A method is a structured procedure for br ...

proposed by

Franco Modigliani Franco Modigliani (18 June 1918 – 25 September 2003) was an Italian-American economist and the recipient of the 1985 Nobel Memorial Prize in Economics. He was a professor at University of Illinois at Urbana–Champaign, Carnegie Mellon Un ...

and

Merton Miller Merton Howard Miller (May 16, 1923 – June 3, 2000) was an American economist, and the co-author of the Modigliani–Miller theorem (1958), which proposed the irrelevance of debt-equity structure. He shared the Nobel Memorial Prize in Economic ...

for the calculation of the weighted average cost of capital of a

corporation A corporation is an organization—usually a group of people or a company—authorized by the state to act as a single entity (a legal entity recognized by private and public law "born out of statute"; a legal person in legal context) and ...

Case B

*Consider the investor now has an option to borrow $4,000 at 8% interest rate. *If the investor still pays $1,000 of his initial equity capital, in addition to borrowing $4,000 at the terms above, the investor can purchase 5 units of investment for $5000 total. *At the end of the year, he will have: ($5,000 return of capital, $500 revenue (due to the 10% return on each unit of investment), –$4,000 repayment of debt, –$320 interest payment, and $(500-320)*20%= $36 tax). Therefore, he is left with $1,144. He earned net income of $144, or 14.4% return on his $1000 initial equity capital. The reason that he was able to earn additional income is because the cost of debt (i.e. 8% interest rate) is less than the return earned on the investment (i.e. 10%). The 2% difference makes income of $80 and another $100 is made by the return on equity capital. Total income becomes $180 which becomes taxable at 20%, leading to the net income of $144.

Value of the Tax Shield

In most business valuation scenarios, it is assumed that the business will continue

forever Forever or 4ever may refer to: Film and television Films * ''Forever'' (1921 film), an American silent film by George Fitzmaurice * ''Forever'' (1978 film), an American made-for-television romantic drama * ''Forever'' (1992 film), an American ...

. Under this assumption, the value of the tax shield is: (interest bearing debt) x (tax rate). Using the above examples: *Assume Case A brings after-tax income of $80 per year, forever. *Assume Case B brings after-tax income of $144 per year, forever. *Value of firm = after-tax income / (return of capital), therefore *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;

References

{{DEFAULTSORT:Tax Shield Debt Tax terms de:Tax Shield fr:Bouclier fiscal zh:稅盾

Example

Case A

Case B

Value of the Tax Shield

See also

References