Tax Shield How does Tax Shield Save on Taxes? Uses of Tax Shield

For example, the cost of equity is traditionally estimated by CAPM model. However, if the company is non-listed, the model is inappropriate or inaccurate. Also the weighted average cost of capital is difficult to quantify. Damodaran has created the database to help estimate the cost of equity and debt.

The cost of interest appears elsewhere on the cash flow statement as a payment to the lender. However, this is the cost of doing business that the company would incur regardless of its tax implications. A reduction in taxable income achieved by claiming allowable deductions is a tax shield. A tax shield is a way to save cash flows and increases the value of a firm. Tax shields take different forms, but most involve some type of expenditure that is deductible from taxable income. A tax shield can be described as a reduction in taxes that results from availing an allowable deduction from taxable income.

The Depreciation Tax Shield in 2 Steps

Implementing an effective tax shield strategy can help increase the total value of a business since it lowers tax liability. For example, let’s say that you pay out a certain amount of funds for a charitable contribution.

Booth et al. investigated capital structure in developing countries. They found that capital structure in developed and developing countries are affected by same firm-specific factors . Nevertheless, they found out that there are differences such as GDP growth, capital tax shield market development and inflation rates. The market value of debt is known and debt is perfectly correlated with the value of interest tax savings. Therefore, debt and tax shield are equally risky; both components should be discounted at the same discount factor .

Tax shield

So, you could say that taking on debt has a tax benefit because you can use the interest as a tax-deductible https://www.bookstime.com/ expense. Beyond Depreciation Expense, any tax-deductible expense creates a tax shield.

The money a business saves from a tax shield is cash it doesn’t need to pay to the government as tax. A tax shield will allow a taxpayer to reduce their taxable income or defer their income taxes to a time in the future.

Corporate debt management and the value of the firm

Indicates that the value of tax shield should be a function of EBIT plus OI and not a function of the net income as Liu argued in his theory. Expresses the relation between the dependent and independent variables. Arzac and Glosten , based on the approach of Miles and Ezzell, developed a unique method which eliminates the discount rate. They derived the formula for the company market value, for the market value of equity and for market value of tax shield using an iterative process. The Miles and Ezzell and Harris and Pringle models are the most commonly applied approaches while the constant leverage is assumed.