Interest Tax Shields Meaning, Importance And More

interest tax shield

It adds value to a business which is important for that person who wants to sell the business or get loans as well as investors. By comparing the above two options calculated, we concluded that the present value in the case of buying by taking a tax shield is lower than the lease option. It also means companies have more money available to reinvest back into the business for higher growth. And this effect is driven exclusively by the interest tax shield. This is equivalent to the firm’s total profit of $80 million. Thanks to the interest tax shield, Company B can essentially save 20% of that $10 million, which amounts to a $2 million. Both companies have an Earnings Before Interest and Tax equal to $100 million.

Let’s look at the example of an owner of a fleet of trucks whose equipment depreciated over the tax year. Depreciation is a deductible expense, and a portion of the depreciated amount can therefore lessen the owner’s overall tax burden. Tax shields are legal and should not be confused with illegal failures to pay taxes, known as tax evasion. Joshua Wiesenfeld is a financial investigator, certified public accountant , and certified fraud examiner with almost a decade of experience. He writes about taxes and investing and has been published in the Journal of Accountancy and Fraud Magazine.

Value of the Tax Shield

Decrease cash on hand, but they put money into investments that provide a higher return. The interest may be too high in that the taxpayer may find himself not able to make the payments. Duration of assets ownership and whether it played a part in building capital for improvement. Cash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment.

interest tax shield

Instead, you should add back the original expense multiplied by one minus the tax rate. This is because the net effect of losing a tax shield is losing the value of the tax shield, but gaining back the original expense as income.

How to Calculate Tax Shield

A company’s financial accounting provides information about its performance and financial position, but it also allows business leaders to take advantage of opportunities to save money. Saving by using items such as tax shields affects a company’s cash flow, which is the rate at which money enters and leaves the business. So, before you decide to take on debt for the purpose of benefiting from interest tax shield, it is essential that you understand how it works. Debt is an important part of business valuation, but too much debt may impact future cash flows as well.

Suppose company X owes $20m of taxes, pays $5m of interest expense, and has a tax rate of 30%. Keep in mind that an ITS is a strategy used tax shield to decrease the tax liability of an individual, entity, or firm. However, tax evasion is a different case and is illegal and unethical.

Straight-Line vs. Accelerated Depreciation Approaches

So the weight on debt is 0.6, and the weight on equity is 0.4. Expenses are tax deductible, it reduces the tax liability the company has to pay. The net income for companies A and B is $192,500 and $231,000 after subtracting taxes.

  • The value of unlevered and levered company according to Fernandez .
  • Interest expense is an important part of a company’s income statement (or ‘profit and loss’ or ‘statement of financial performance’).
  • The debt-to-equity ratio will be kept constant throughout the life of the project.
  • Keep in mind that an ITS is a strategy used to decrease the tax liability of an individual, entity, or firm.
  • The deductible interest paid on debt obligations reduces a company’s taxable income.
  • A tax shield is the reduction in income taxes that a company achieves due to the use of certain tax-deductible expenses.
  • When these bonds mature, new bonds will be re-issued, and so on in perpetuity.

One of the advantages of the model is that it is not necessary to estimate weighted average cost of capital. The first of the analyzed theories is the model of Modigliani and Miller , which is outlined in the previous section. According to the assumptions of the model, the company can borrow and lend money on perfect capital markets at risk-free rate and market value of debt is constant.