To understand this, you first need to have a reasonable understanding of corporate taxes. Net present value (NPV) is the difference between the PV of the cash coming in and going out of a firm in a given period. NPV is used in capital budgeting and investment planning to analyze the profitability of an investment or project. However, it also considers the potential costs of financial distress that might arise from high levels of debt, as well as other financing-related impacts like subsidies or hedging.
Interest Tax Shield for Businesses
For instance, you can deduct interest costs of up to $ 2,500 on a student loan per year. When a business saves money on taxes directly from paying interest on debt, this is referred to as an interest tax shield. In light of this, the debt is subsidized by tax shielding of interest. Naturally, this is very much country-specific, but it’s fair to say that interest tax shields aren’t solely for corporations.
Types of tax shields
A tax shield in capital budgeting is a way for corporations to strategically plan their optimal capital structure and decide which investments to follow. This, in turn, makes debt funding much cheaper since interest expenses on debt are tax-deductible. Corporations use tax shields strategically to receive tax benefits. They often do this in one of two ways, either through capital structure optimization or accelerated depreciation methods. There are many examples of a tax shield, and it often depends on the tax rate of the corporation or individual as well as their tax-deductible expenses.
Discontinuous financing based on market values and the value of tax shields
An interest tax shield is simply savings by deducting interest costs for profits and ultimately reducing the tax payable amount. Implementing an effective tax shield strategy can help increase the total value of a business since it lowers tax liability. Interest expenses on certain debts can be tax-deductible, which can make the entire process of debt funding much easier and cheaper for a business. This works in the opposite way to dividend payments, which are not tax-deductible.
As shown in our example above, a business with debt financing will benefit from an interest tax shield and hence will pay a lower tax amount. For instance, if your allowable interest tax cost is $2,000 and the effective tax rate is 25%, then your interest tax shield will be $500. The first step in calculating the interest tax shield is to know the limit of tax-deductible interest expenses.
- The company can also acquire the equipment on lease rental basis for $15,000 per annum, payable at the end of each year for three years.
- Instead, the value is depreciated over the useful life of the asset, and that expense is deducted on the tax return.
- It can also depend on the type of taxable expenses being used as a tax shield.
- To get the APV, you first calculate the base case value, which is the NPV of the company or project as if it were financed entirely with equity.
- The interest tax shield has to do with the tax savings you can receive from deducting various interest expenses on debt.
- Commercial loans often come with other types of expenses like loan originating fees.
Larger companies can also benefit from carrying debt even though they may have larger cash stockpiles. For that reason, newer companies might see loans as a more efficient source of capital. And debt can often be a necessary part of a company’s ability to operate. Company debt is usually a much larger amount of money than individuals have to worry about. This improves several financial ratios that investors use to value the company, such as those that compare the revenues to profits.
For instance, individual taxpayers commonly use student loans and mortgage interest costs as tax-deductible expenses. Okay, now that you have a reasonable understanding of corporate tax and tax deductible expenses, let’s dive into the interest tax shield. With debt financing and reduced income tax, Company X would have more tax shield cash available to support its future development and growth plans. For funding their expansion and growth plans, companies often prefer debt over equity capital. The reason is that the interest on debt capital is a tax admissible expense under most of the tax jurisdictions while the dividend paid on equity capital is not.
APV vs. Discounted Cash Flow (DCF)
How Can APV Be Used by Corporate Managers for Capital Budgeting?
