# Tax shield: Wikis

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# Encyclopedia

A tax shield is the reduction in income taxes 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.

## Example

### Case A

Consider one unit of investment cost \$1,000 and returns \$1,100 at the end of year 1. 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 (+\$1,000 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 –\$36 tax) considering \$1000 initial capital 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 capital (opportunity cost, 8%) is not deductible for tax purposes, but the cost of debt (interest, 8%) is.

### 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:

• 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
• Debt x tax rate: \$4,000 x 20% = \$800;

(This is applicable only in case of IRR=interest rate; Assume the interest rate at 10%;You earn nothing from the borrowed \$4,000,thus no increase in the value of the firm; no tax shield effect--No profit,NO tax!)