Tax shield

A tax shield is the reduction in income taxes that results from taking an allowable deduction from taxable income.^[1] For example, because interest on debt is a tax-deductible expense, taking on debt creates a tax shield.^[1] 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.

• Consider one unit of investment that costs 1,000ドル and returns 1,100ドル 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ドル of capital, at the end of the year, he will have (1,000ドル return of capital, 100ドル income and –20ドル tax) 1,080ドル. He earned net income of 80,ドル or 8% return on capital.

The concept was originally added to the methodology proposed by Franco Modigliani and Merton Miller for the calculation of the weighted average cost of capital of a corporation.

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

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 after-tax income of 80ドル per year, forever.
• Assume Case B brings after-tax income of 144ドル per year, forever.
• Value of firm = after-tax income / (return of capital), therefore
• Value of firm in Case A: 80ドル/0.08 = 1,000ドル
• Value of firm in Case B: 144ドル/0.08 = 1,800ドル
• Increase in firm value due to borrowing: 1,800ドル – 1,000ドル = 800ドル
• Alternatively, debt x tax rate: 4,000ドル x 20% = 800ドル;

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

• Debt
• Tax terms

• Articles with short description
• Short description matches Wikidata