# Tax shield

Tax shield

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 on 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

ee also

*Valuation (finance)

* [http://papers.ssrn.com/sol3/papers.cfm?abstract_id=790844 The Value of Tax Shields IS Equal to the Present Value of Tax Shields]
* [http://www.investopedia.com/terms/t/taxshield.asp Tax Shield at Investopedia.com]

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### Look at other dictionaries:

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