Understanding the Tax Shield in Corporate Finance
Tax shield refers to the reduction in taxable income that results from taking advantage of allowable deductions, such as interest expenses on debt.
This means that a company can reduce their taxable income by deducting the interest payments made on their debt from their taxable income. The tax shield is calculated by multiplying the amount of the deductible expense by the tax rate.The formula for calculating the tax shield is:
Tax Shield = Deductible Expense x Tax Rate
For example, if a company has $5 million in interest expense on their debt and the tax rate is 35%, the tax shield would be:
Tax Shield = $5 million x 35% = $1.75 million
This means that the company can reduce their taxable income by $1.75 million, resulting in a lower tax bill.
One real company example of using tax shield is
Apple Inc. In 2019, Apple had $108 billion in cash reserves and issued $7 billion in debt. Apple used the proceeds from the debt to repurchase their own shares, which helped to increase their earnings per share. The interest payments on the debt were tax-deductible, which allowed Apple to reduce their taxable income and lower their tax bill.
However, if the interest payment on debt gets taxed, it means that the company cannot deduct the interest expense from their taxable income. This can have a significant impact on a company's finances, as they would have to pay taxes on the full amount of their income without taking into account any interest expense incurred.
This, in turn, can reduce the company's net income, cash flow, and potentially their ability to invest in new projects or pay dividends to shareholders.
In conclusion, tax shield can be a valuable tool for companies to reduce their taxable income and lower their tax bills. However, if interest payments on debt are taxed, it can have a significant impact on a company's finances and their ability to finance their operations and growth.