Tax shield
In today's world, Tax shield has captured the attention of millions of people around the world. Whether due to its impact on society, its historical relevance or its influence in the cultural field, Tax shield has become a topic of interest in various areas. From its emergence to the present, Tax shield has left its mark on people's lives, sparking debates, reflections and studies around its meaning and impact. In this article, we will explore various aspects related to Tax shield, analyzing its importance and implications today.
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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.
Example
Case A
- Consider one unit of investment that costs $1,000 and returns $1,100 at the end of year 1, i.e. a 10% return on investment before taxes.
- Now 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.
The concept was originally added to the methodology proposed by Franco Modigliani and Merton Miller for the calculation of the weighted average cost of capital of a corporation.
Case B
- Consider the investor now has an option to borrow $4,000 at 8% interest rate.
- If the investor still pays $1,000 of his initial equity capital, in addition to borrowing $4,000 at the terms above, the investor can purchase 5 units of investment for $5000 total.
- At the end of the year, he will have: ($5,000 return of capital, $500 revenue (due to the 10% return on each unit of investment), –$4,000 repayment of debt, –$320 interest payment, and $(500-320)*20%= $36 tax). Therefore, he is left with $1,144. He earned net income of $144, or 14.4% return on his $1000 initial equity capital.
The reason that he was able to earn additional income is because the cost of debt (i.e. 8% interest rate) is less than the return earned on the investment (i.e. 10%). The 2% difference makes income of $80 and another $100 is made by the return on equity capital. Total income becomes $180 which becomes taxable at 20%, leading to the net income of $144.
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 after-tax income of $80 per year, forever.
- Assume Case B brings after-tax income of $144 per year, forever.
- Value of firm = after-tax income / (return of capital), therefore
- 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 borrowing: $1,800 – $1,000 = $800
- Alternatively, debt x tax rate: $4,000 x 20% = $800;
See also
References
- ^ a b Kemsley, Deen; Nissim, Doron (October 2002). "Valuation of the Debt Tax Shield" (PDF). The Journal of Finance. 57 (5): 2045–2073. doi:10.1111/0022-1082.00488. Retrieved 25 March 2013.
