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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.

Contents

Example

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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!)

See also

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