After-Tax Cost of Debt
I don't conceptually understand how you 'save' money using interest payments as a tax shield....e.g. $10k in interest payments @ 40% effective tax rate, you're only effectively paying $6k in interest payments and 'saving' $4k..but you arent saving anything? You're paying $10k as an expense so obviously it lowers your income and therefore taxable income. Why is it the common tongue to say interest expense/debt is a tax shields when it seems to me it's just an expense
Hopefully this will help. Let’s assume you have $100 of revenue, no expenses, and a 20% rate. You will pay $20 worth of taxes, and your net income will be $80. Now, if you throw in a $10 interest expense, you will pay $18 worth of taxes ($90*20%), and your net income will be $72. So while interest was $10, your net income only fell be $8, hence a $2 “saving”. So while you don’t save by paying interest directly, you pay lower taxes, which is why interest is considered a tax shield.
Probably best to think about it in comparison to something that isn’t tax deductible to understand why. Like the above example, 100 rev, no expenses , 20% tax rate: taxes are 20. Now you throw in $10 of interest expense, your taxes are now 18.
But let’s say you don’t have any debt, and decide to pay $10 worth of dividends. You are still paying $20 in taxes, as the dividend payments aren’t tax deductible.
You can think of this example as a business owner deciding whether to raise capital through debt or equity and goes to show the attractiveness of debt (as well as not diluting your ownership)
Thanks. And yes your taxes go down from 20 to 18, but that's because your taxable income is down (because you have an expense) so i dont really see any value-add in that. The dividend examples makes a lot of sense. So essentially a business owner can borrow debt, pay themselves a dividend, and this is cheaper because their taxable income is lower?
yes, but you also have the cash on the balance sheet that otherwise would have been out the door.
The $2 in tax savings?
yes.
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