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.

Example

Case A

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.

Case B

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. Under this assumption, the value of the tax shield is: (interest bearing debt) x (tax rate).

Using the above examples:

See also

References

  1. 1 2 Kemsley, Deen; Nissim, Doron (October 2002). "Valuation of the Debt Tax Shield" (PDF). The Journal of Finance. 57 (5): 2045–2073. doi:10.1111/0022-1082.00488. Retrieved 25 March 2013.

External links

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