Tax shield

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A tax shield is a reduction in income tax resulting from taking the allowable deductions from taxable income. For example, since interest on debt is a cost that is tax deductible, taking on debt creates a tax shield. Because tax shields are a way to save cash flow, it increases business value, and this is an important aspect of business valuation.

Video Tax shield

Example

Case A

• Consider an investment unit worth $ 1,000 and generate $ 1,100 by the end of year 1, which is a 10% return on your investment before tax.
• Now, assume a 20% tax rate.
• If an investor pays $ 1,000 of capital, by the end of the year, he will have ($ 1,000 payback, $ 100 revenue and - $ 20 tax) $ 1,080. It generates a net profit of $ 80, or an 8% payback.

This concept was initially added to the methodology proposed by Franco Modigliani and Merton Miller for the calculation of the weighted average cost of company capital.

Case B

• Consider investors now have the option to borrow $ 4,000 at 8% interest.
• If the investor still pays $ 1,000 of his initial capital, in addition to borrowing $ 4,000 on the above provisions, the investor can buy 5 units of investment for a total of $ 5000.
• At the end of the year, he will have: ($ 5,000 payback, $ 500 income (due 10% return on each investment unit), - $ 4,000 debt payment, - $ 320 interest payment, and $ (500-320) * 20% = tax $ 36). Therefore, he is left with $ 1,144. He earned a net income of $ 144, or a 14.4% return on initial capital of $ 1,000.

The reason that he is able to earn extra income is because the cost of debt (ie 8% interest rate) is less than the profit earned from the investment (ie 10%). A 2% difference generates $ 80 and $ 100 in revenues generated by return on equity capital. The total income becomes $ 180 which becomes taxable at 20%, leading to a net profit of $ 144.

Value of Tax Shield

In most business valuation scenarios, it is assumed that the business will continue forever. With this assumption, the value of the tax shield is: (interest bearing debt) x (tax rate).

Using the example above:

• Assume Case A brings in after-tax income of $ 80 per year, forever.
• Assume Case B brings in after-tax income of $ 144 per year, forever.
• Company value = income after tax/(payback), therefore
• The company value in Case A: $ 80/0,08 = $ 1,000
• The company value in Case B: $ 144/0,08 = $ 1,800
• Increased corporate value due to borrowing: $ 1,800 - $ 1,000 = $ 800
• Alternatively, debt x tax rate: $ 4,000 x 20% = $ 800;

Maps Tax shield

See also

• Current customized values ​​
• Capital cost
• Rating (financial)

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References

src: cdn.corporatefinanceinstitute.com

External links

• The Value of Tax Shield IS Equals Current Value of the Tax Shield
• Tax Shield at Investopedia.com

Source of the article : Wikipedia