Tax Shields and Their Applications

Definition

• Tax Shield: An allowable deduction that saves money on a tax bill.
• Varies by country based on eligibility and legality.

Common Tax Shield Deductions

• Depreciation Expense
• Amortization Expense
• Interest Expense

Importance of Tax Shields

• Value depends on:
  • Effective tax rate
  • Value of deductions

Main Uses of Tax Shields

1. Capital Structure Optimization

• Interest Expense: Tax-deductible.
• Cost of Equity: Not tax-deductible (dividends aren’t deductible).
• Debt Funding: Cheaper than equity funding due to tax deductions.

2. Accelerated Depreciation Methods

• Depreciation: Non-cash expense.
  • Companies accelerate depreciation to lower taxable income.
  • Lower taxable income means lower cash taxes.

Example Calculations

• Tax Yield Formula: Deduction x Tax Rate.

Example Scenario

• Debt Balance: $8 million
• Interest Rate: 10%
• Tax Rate: 35%

Calculation

• Interest Expense Deduction: $8 million x 10% = $800,000
• Interest Tax Yield: $800,000 x 35% = $280,000 (in one year)

Net Present Value (NPV) of Tax Shield

• NPV equals tax shield in each year of the bond's life, discounted back to the present.

Conclusion

• Tax shields are crucial for lowering taxable income and reducing taxes for companies.