Tax Shield

A Tax Shield is an eligible deduction for a person or company from taxable income gained by claiming permissible deductions such as mortgage interest, medical costs, charitable contributions, amortization, and depreciation. Tax shields differ between countries and are supported by what deductions are eligible versus ineligible. For instance, because interest on the debt could be a tax-deductible expense, usurping debt creates a tax shield. Such deductions minimize the taxable income of a taxpayer for a given year or delay taxation on wages in future years.

The value of tax shields depends on the effective charge per unit for the corporation or individual (being subject to a better rate increases the worth of the deductions). Tax shields lower the amount of taxes owed by a personal taxpayer or a business. Since a tax shield maybe thanks to save cash flows, it increases the worth of the business, and it’s a very important aspect of business valuation. Common expenses that are deductible include depreciation, amortization, mortgage payments, and disbursement.

The term “tax shield” refers to the ability of a given deduction to protect parts of taxpayer income from taxation. All businesses and people enjoy the benefits of tax shields. Tax shields vary from country to country, and their advantages depend on the total tax rate and cash flow of the taxpayer for the year in question.

For certain examples of company valuation, the company is believed to continue indefinitely. Investment approaches that are tax-efficient are the cornerstones of investing for high net worth individuals and companies whose annual tax bills can be very high. There are two main strategies companies use:

Capital structure optimization – The impact of adding/removing a tax shield is important enough that companies will take it into consideration when considering their optimal capital structure, which is their mixture of debt and equity funding. Since the disbursal on debt is tax-deductible (while dividend payments on equity shares are not) it makes debt funding that less expensive.

Accelerated depreciation methods – Considering that depreciation expenses are tax-deductible, corporations usually tend to reduce depreciation expenses on their tax returns as soon as they can. Corporations can use a variety of different methods of depreciation, such as double-decreasing balance and sum-of-year digits, to reduce taxes in the early years.

Initially, the term ‘Tax Shield’ was applied to the approach introduced by Franco Modigliani and Merton Miller for estimating a corporation’s weighted average capital costs. Calculating the tax shield can be simplified by using this formula:

Tax Shield = Value of Tax-Deductible Expense x Tax Rate

So, for instance, if we have $1,000 in mortgage interest and our tax rate is 24 percent, our tax shield will be $240.

The ability to use a home mortgage as a tax shield could be a major advantage for several middle-class people whose homes are important components of their net worth. It also provides incentives to those inquisitive about purchasing a home by providing a selected tax write-off to the borrower. Thus, the benefit comes from the value of cash and pushing tax expenses out as far as possible. Since depreciation could be a non-cash expense and tax could be a cash expense there’s a real-time value of cash saving.

 

Information Sources:

  1. investopedia.com
  2. corporatefinanceinstitute.com
  3. wikipedia