Interest Tax Shields

A form of tax saving or reduced tax liability from payments of interest expense through the use of debt financing.

Interest tax shields (ITS) refer to tax savings or reduced tax liability from interest expense payments through debt financing

Interest Tax Shields

The interest payment to debt holders can lower the taxable income from which firms, companies, and even individuals can benefit and use it as an advantage to reduce their tax expenses. This benefit has become an incentive for firms and individuals to finance their projects using debt.

The effect of interest tax shields can be seen in a profit/loss statement (income statement) in the non-operating income/expenses section. The overall impact will either increase profits or decrease losses.

Most companies, firms, and corporations benefit greatly from the interest tax rate by using debt in their capital structure. However, individuals can also receive and take advantage of the benefit. 

An example would be purchasing a house through a loan or a mortgage. The interest expenses that the individual needs to pay for the loan or the mortgage acts as a tax shield and can be used to reduce the tax liability.

Overall, many types of interest are tax-deductible, and that includes borrowing expenses like:

  • Mortgage interest for both first and second mortgages (home equity)
  • Mortgage interest for investment properties
  • Student loan interest
  • Interest on business loans, business credit cards, etc.

Keep in mind that an ITS is a strategy used to decrease the tax liability of an individual, entity, or firm. However, tax evasion is a different case and is illegal and unethical. In simple terms, tax evasion is the act of avoiding paying taxes.

Tax evasion involves illegal deductions or not reporting the right amount of income. This act of illegal tax avoidance is a crime and is accountable for penalties and criminal prosecution.

Interest tax shield vs. Depreciation tax shield

As the interest tax shield uses interest expenses from debt to produce the tax shield, the depreciation tax shield utilizes the cost of depreciation to create the tax shield. 

Similar to how ITS work, depreciation expense can also be tax deductible, where its tax shield can be calculated by multiplying the applicable tax rate with the depreciation expense.

For instance, if the tax rate is 30% and the depreciation expense is $1000, the tax shield would be $300. Depreciation tax shields are commonly used in industries where it is asset-intensive or where many machines, equipment, and other fixed assets can be depreciated. 

Example of depreciation tax shield

Example
 With depreciation ($)Without depreciation ($)
Profit Before Depreciation10001000
Depreciation expense(250)-
Profit After Depreciation7501000
Tax Rate23%23%
Tax Paid172.5230

The depreciation tax shield is the difference between the tax paid with and without the depreciation expense. The above example shows the tax shield is $57.5 (230-172.5).

Example, Formula and Calculation

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Example 1

Assume Company X, like any other company, pays taxes and uses debt as one of its primary sources of income. Company X is likely to pay a form of compensation to the banks known as the cost of debt, which is the interest rate. 

The payment of the interest rate is a cost to the company. However, it can be used to offset the payment of taxable income, reducing tax liability or expense. A more detailed explanation will be shown below.

The value can be calculated by the interest expense multiplied by the company's tax rate.

 Interest Tax Shield = Interest expense * Tax Rate

Suppose company X owes $20m of taxes, pays $5m of interest expense, and has a tax rate of 30%. 

"The value of the interest tax shield will be $1.5m ($5m * 30%). This will reduce the company's tax liability to $18.5m from $20m ($20m - $1.5m)."

Example 2 

In this example, we will compare the income statement of 2 companies where one pays interest expenses while the other doesn't. 

Assume that "Company A" uses debt in its capital structure and is obligated to pay interest payments. "Company B," on the other hand, only utilizes equity financing and therefore is not obligated to pay any interest.

Dollar

We will also assume that all other variables in the income statement are constant except for the interest expense. In this way, we can observe the effect of the ITS on the income statement.

For both companies, revenue will be $1m, the cost of goods sold is $600k, and operating expenses will be $100k. However, starting from there is where the financials start to differ. 

Company A, which uses debt, will incur interest expense, in this case, $50k. Company B is unleveraged and will pay no such expenses.

Due to the interest payments, Company B will receive ITS. For a tax rate of 23%, Company A is eligible for an $11.5k payment ($50k*23%). Since Company B has no debt, they are ineligible. 

The earnings before tax (EBT) is 250k for company A, less the operating and interest expense. For Company B, the earnings before tax (EBT) is $300k.

The tax rate is 23%, where the tax for Company A is $57.5k, and the tax for Company B is $69k. The difference between the two figures is the interest tax shield of $11.5k.

The net income for companies  A and B is $192,500 and $231,000 after subtracting taxes. Even though Company B has a higher net income in the income statement, Company A would hold more cash on hand from using debt. Likewise, they can also take advantage of the tax savings from the interest expense.

Income Statement
Income Statement20222022
 Company A ($)Company B ($)
Revenue1,000,0001,000,000
Less: COGS(600,000)(600,000)
Gross Profit400,000400,000
Less: Operating Expense(100,000)(100,000)
Less: Interest Expense(50,000)-
Earnings before Tax (EBT)250,000300,000
Tax (23%)(57,500)(69,000)
Net Income 192,500231,000
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Reward and risks

The perks of using debt by many firms and corporations in their capital structure are to utilize the tax shield to help offset the loss from the interest expense. Moreover, with interest expense on debt tax-deductible and dividends to common equity holders not, debt financing can be considered as the cheaper source of financing.

Coins

Despite its valuable benefits, ITS can still be risky. One common reason is the fear of being unable to meet the interest payments, which is a financial risk to the company. In addition, the greater the tax shield means larger portions of debt for the firm. 

The other reason is due to covenants which are the restrictions on the company or firm that needs to be agreed upon when taking on debt. So basically, it ensures that the company meets its financial obligations. 

Examples include maintaining a certain ratio level, such as the Debt to Equity ratio or the Debt to Coverage ratio. Failure to meet these covenants will lead to more expensive debt and financial pressure on the company. This includes higher amounts of collateral where the firm may also be demanded to pay the total amount of the loan immediately. 

effect on capital structure

The benefits have encouraged firms, companies, and even individuals to take on more debt in their financial structure. 

Building

Issuing equity requires more time, effort, and cost. In addition, the dividend paid on equity is not tax-deductible; the tax shields motivate the company to utilize a higher portion of debt in its capital structure.

WACC

There are costs associated with using debt and equity in the capital structure, and this needs to be compensated to the investors and lenders for taking on the risks of providing the capital. 

The WACC tells us the combined costs of both debt and equity and can be used as a discount rate to value projects.

Since debt financing uses interest expenses as the cost of capital and interest expenses are tax deductible, it reduces the tax liability the company has to pay. 

As a result, the cost of debt is adjusted lower to reflect the tax adjustments from the benefits of the interest payments.

It, thus, overall lowers the WACC of the company.

Calculation of WACC with ITS

The formula of WACC, which takes into account the tax shield, is:

WACC = (wD x rD)(1 - T) + (wE x rD)

  •  wD is the weight of debt 
  •  wE is the weight of equity 

Note: Weight of debt and equity always adds up to 1 (wD + wE = 1)

Let's say that the cost of debt is 0.05, and the cost of equity is 0.08. So the weight on debt is 0.6, and the weight on equity is 0.4. The tax rate is 34%.

The WACC will be (0.6 x 0.05)(1 - 0.34) + (0.4 x 0.08) = 0.0518 or 5.18%

Without the tax shield, the WACC will be (0.6 x 0.05) + (0.4 x 0.08) = 0.062 or 6.2%

In this example, the tax shield lowers the WAAC by 0.0102 or 1.02% (6.2% - 5.18%) to 5.18% (0.0518) from an initial of 6.2% (0.062).

In conclusion, the effect of the tax shield lowers the firm's WACC or the cost of capital. The higher the income tax rate, the greater the tax shield generated and the lower the company's WACC. 

Effect of Valuation using ITS

ITS plays an essential role in valuing firms and companies. The adjusted present value (APV) is one of the valuation methods used to take the calculation into account of interest tax shields. 

Home loan

The Adjusted Present value can be divided into two parts which involve the company's present value if only financed by equity plus the present value of any benefits arising from financing (example of these includes ITS generated from debt). 

The primary purpose of the APV is to bring out the benefits of the tax shields from payments of interest expenses that are tax deductible. In addition, including ITS in valuation creates a higher value for these companies or firms.

Unlike discounted cash flow (DCF) which uses WACC to discount its projects, the APV uses the cost of equity and the cost of debt separately since the APV divides its calculation into two parts. This means two different discount rates for each part of the calculation.

Formula and APV Calculation

APV = Unlevered firm value + interest tax shield

(carrying no debt)

  • The unlevered firm value is equal to the present value of the expected future unlevered free cash flow discounted at the rate of the unlevered cost of equity (Ku).
  • The value of the interest tax shield is equal to the present value of the expected future tax shields discounted at the rate of the cost of interest tax shields (KITS).

Assume for simplicity that Company X has a present value + terminal value of $1m. The tax rate is 30%, its interest rate is 5%, and a debt of $500k. The ITS is calculated by multiplying the total amount of debt by the tax rate and the interest rate.

We then also have to divide it by the interest rate to find the present value of the interest tax shield. The final value of the interest tax shield is $150k or ($500k * 5% * 30%) / 5%. Thus the overall Adjusted Present Value or APV is $1m + $150k = $1.15m.

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APV Valuation: who uses it and why? 

In general, the Adjusted Present value differs from other valuation methods due to the inclusion of the tax shields. It helps show the benefit of the tax deduction of interest payments. 

This valuation method reveals the value of debt and shows that a project financed with debt may be valued higher than a project solely financed by equity. 

The inclusion of debt often decreases the cost of capital and may turn negative NPV projects into positive ones. 

The APV is commonly used in many leveraged transactions, including leveraged buyouts, which are the most effective and preferred situations to use this valuation method.

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Researched and Authored by Viriyan Dharma 

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