Here, Company A will carry no debt on its balance sheet (and thus have zero interest expense), whereas Company B will have $4m in interest expense.
The payment of interest expense reduces the taxable income and the amount of taxes due – a demonstrated benefit of having debt and interest expense. The tax shield strategy can be used to increase the value of a business, since it reduces the tax liability that would otherwise reduce the value of the entity’s assets. The effects of the tax shield should be used in all cash flow analyses, since the amount of cash paid in taxes is impacted.
Below, we take a look at an example of how a change in the Depreciation method can have an impact on Cash Flow (and thus Valuation). As you can see from the above calculation, the Depreciation Tax Savings as the expense increases. Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia. As shown in the completed output above, Company B’s taxes were $840k lower than Company A’s taxes.
How to Calculate Tax Shield
There are a variety of deductions that can shield a company (or Individual) from paying Taxes. For both companies, the financials are the same until the operating income (EBIT) line, where each has an EBIT of $35m. As a cost of borrowing, the borrower must make Interest payments for the benefit of borrowing. In the section below, we cover two of the most common methods and their Cash Flow and Valuation impacts. The Interest Payments are typically tax-deductible, which lowers the Company’s tax bill.
But once the interest expense is accounted for, the two companies’ financials begin to differ. Since Company A has no non-operating expenses to factor in, its taxable income remains at $35m. But since the WACC already factors this in, the calculation of unlevered free cash flow does NOT account for these tax savings – otherwise, you’d be double-counting the benefit. However, to be able to qualify for this kind of tax shield, as a taxpayer you will have to itemize deductions on your tax returns. Another qualification is that there must be an approved organization receiving the donations. 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%).
Wrap-Up: Depreciation Tax Shield
The lower the taxable income, the lower the amount of taxes owed to the government, hence, tax savings for the taxpayer. When adding back a tax shield for certain formulas, such as free cash flow, it may not be as simple as adding back the full value of the tax shield. Instead, you should add back the original expense multiplied by one minus the tax rate. This is because the net effect of losing a tax shield is losing the value of the tax shield, but gaining back the original expense as income.
- For depreciation, an accelerated depreciation method will also allocate more tax shield in earlier periods, and less in later periods.
- When we increase FE from 0 to 150, in that case, net income decreases from 120 to 30, and the net reduction is 90, and TS remains the same 60.
- Given the decreased taxable income, Company B’s taxes for the current period are approximately $6.5m, which is $840k lower than Company A’s $7.4m in taxes.
- There are cases where income can be lowered for a certain year due to previously unclaimed tax losses from prior years.
- Tax shield for an individual is beneficial when you want to buy a home, using a mortgage or a loan.
This is because the mortgages interest expenses are tax-deductible, making it cheap to pay since it reduces tax liability. Interest loan for students is also another tax shield for an individual, which is also tax-deductible making it cheaper. It should be noted that regardless of what depreciation method is used the total expense will be the same over the life of the asset. Thus, the benefit comes from the time value of money and pushing tax expenses out as far as possible. Since depreciation is a non-cash expense and tax is a cash expense there is a real-time value of money saving. When deciding to take a mortgage to purchase a building for their business, a tax shield will be created as a result.
On the other hand, Company B’s taxable income becomes $31m after deducting the $4m in interest expense. 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. The taxes saved due to the Interest Expense deductions are the Interest Tax Shield. With the two methods clarified, let’s look at the Cash Flow impact of each approach. Also, at higher tax rates, Depreciation is going to provide additional savings.
Straight-Line vs Accelerated Depreciation – Valuation Impact
To increase cash flows and to further increase the value of a business, tax shields are used. Since the interest expense on debt is tax-deductible (while dividend payments on equity shares are not) it makes debt funding that much cheaper. The term “tax shield” references a particular deduction’s ability to shield portions of the taxpayer’s income from taxation. Tax shields vary from country to country, and their benefits depend on the taxpayer’s overall tax rate and cash flows for the given tax year.
- In the section below, we cover two of the most common methods and their Cash Flow and Valuation impacts.
- That interest is tax deductible, which is offset against the person’s taxable income.
- This is because mortgage interest is tax-deductible and the deduction applies to the interest and not on the mortgage payment.
For depreciation, an accelerated depreciation method will also allocate more tax shield in earlier periods, and less in later periods. However, it is important to consider the effect of temporary differences between depreciation and capital cost allowance for tax purposes. Tax shields allow for taxpayers to make deductions to their taxable income, which reduces their taxable income.
Interest Tax Shield Example
Below are the Depreciation Tax Shield calculations using the Straight-Line approach. As you can see, the SYD method offers far more Depreciation Expense in the early years than the Straight-Line method. As an alternative to the Straight-Line approach, we can use an ‘Accelerated Depreciation’ method like the Sum of Year’s Digits (‘SYD’).
Want To Learn More About Finance?
So, if they do it later in the year, they will not be in a position to achieve maximum saving on their taxable income. Since depreciation expense is tax-deductible, companies generally prefer to maximize depreciation expenses as quickly as they can on their tax filings. Corporations can use a variety of different depreciation methods such as double declining balance and sum-of-years-digits to lower taxes in the early years. Given that the interest generated from debt is tax-deductible, it makes debt servicing easier for businesses. Note that there is a significant impact when companies add or remove tax shield, therefore, most business owners will always consider their optimal capital structure.
The Debt used in the purchase creates Interest Expense that reduces the acquired Company’s Tax bill. The Interest Tax Shield concept is highly relevant for Leveraged Buyout (‘LBO’) acquisitions executed by Private Equity firms. As you can see, the Taxes paid in the early years are far lower with the Accelerated Depreciation approach (vs. Straight-Line). Below we have also laid out the Depreciation Tax Shield calculations using the Sum of Years Digits approach.
What is Interest Tax Shield?
These deductions reduce the taxable income of an individual taxpayer or a corporation. Generally, corporations that don’t consider tax shields in their planning process are not able to make good savings as far as taxable income is concerned. A good way of maximizing tax shields tax-savings benefits is by putting into consideration the impact of tax shield when making any of their business financial decisions. Also, to get maximum savings, they will need to do their tax planning early enough (at the beginning of the year). This is because the rating of some deductions, such as depreciation happens throughout the year.
There are cases where income can be lowered for a certain year due to previously unclaimed tax losses from prior years. Tax shields allow taxpayers to reduce the amount of taxes owed by lowering their taxable income. When filing your taxes, ensure you are taking these deductions so that you can save money when tax season arrives.