Understanding the Interest Tax Shield

Definition of Interest Tax Shield

The Interest Tax Shield refers to the tax savings a company gains from the deductibility of interest expenses on debt. Since interest payments reduce taxable income, they lower the total amount of taxes owed. This advantage makes debt financing an appealing option for businesses, as it provides a direct financial benefit through tax savings. In addition, businesses may consider a Tax advance to access funds while waiting for the tax savings from the interest tax shield to be realized, improving cash flow in the short term.

Calculating Interest Tax Shield

When a company takes on debt, it incurs interest expenses, which appear in the non-operating income/(expenses) section of the income statement. The tax shield effect helps mitigate the financial burden of interest payments, making debt a strategic tool for businesses.

Since interest payments are tax-deductible, the weighted average cost of capital (WACC) considers this tax advantage. Unlike dividend payments, which are not tax-deductible, interest expenses directly reduce taxable income, making them more cost-effective. Ignoring the tax shield in financial planning can lead to an overestimation of a company’s cost of debt and an undervaluation of the business.

However, since the WACC already incorporates tax advantages, unlevered free cash flow (UFCF) calculations exclude these tax savings to avoid double-counting. UFCF calculations start with net operating profit after taxes (NOPAT), which is derived from EBIT (Earnings Before Interest and Taxes), ensuring a tax-affected operating income metric.

Formula for Interest Tax Shield

The interest tax shield is determined by multiplying the interest expense by the tax rate:

                                Interest Tax Shield = Interest Expense multiplied by the Tax Rate

This formula is only applicable to companies that have a positive taxable income, as tax deductions are ineffective in cases of financial losses.

Example Calculation

Assume a corporate tax rate of 21% and an interest expense of $1 million for a given period. The tax savings derived from the interest tax shield are calculated as follows:

                                             Interest Tax Shield = 21% × $1 million = $210,000

Because interest expenses are tax-deductible while dividend payments are not, debt financing is often viewed as a cost-effective means of raising capital. However, this strategy remains beneficial only as long as the risk of financial distress, such as default or bankruptcy, does not surpass the tax advantages.

Companies aim to optimize the benefits of debt financing without endangering their financial stability. They must ensure that they can meet interest and principal repayment obligations to avoid debt restructuring.

Illustrative Interest Tax Shield Comparison

Consider two companies with identical operating assumptions:

• Revenue = $50 million
• Cost of Goods Sold (COGS) = $10 million
• Operating Expenses (OpEx) = $5 million
• Effective Tax Rate = 21%
• Company A has no interest expense, while Company B incurs $4 million in interest expense.

Both companies have an EBIT of $35 million. However, Company B’s taxable income is reduced to $31 million due to interest expense. As a result, Company B’s tax liability is $6.5 million, compared to Company A’s $7.4 million, yielding tax savings of $840,000:

                                          Interest Tax Shield = $4 million × 21% = $840,000

Although Company A reports a higher net income, Company B benefits from increased cash flow due to debt financing, allowing for reinvestment and growth opportunities.