To install click the Add extension button. That's it.

The source code for the WIKI 2 extension is being checked by specialists of the Mozilla Foundation, Google, and Apple. You could also do it yourself at any point in time.

4,5
Kelly Slayton
Congratulations on this excellent venture… what a great idea!
Alexander Grigorievskiy
I use WIKI 2 every day and almost forgot how the original Wikipedia looks like.
Live Statistics
English Articles
Improved in 24 Hours
Added in 24 Hours
Languages
Recent
Show all languages
What we do. Every page goes through several hundred of perfecting techniques; in live mode. Quite the same Wikipedia. Just better.
.
Leo
Newton
Brights
Milds

From Wikipedia, the free encyclopedia

A tax shield is the reduction in income taxes that results from taking an allowable deduction from taxable income.[1] For example, because interest on debt is a tax-deductible expense, taking on debt creates a tax shield.[1] Since a tax shield is a way to save cash flows, it increases the value of the business, and it is an important aspect of business valuation.

YouTube Encyclopedic

  • 1/3
    Views:
    18 270
    58 937
    1 068
  • Cash flow after deprecition and tax - 2: depreciation tax shield
  • Modigliani and Miller Part 2
  • Managerial Accounting 8.7: The Effect of Income Taxes on Capital Budgeting (NPV and IRR)

Transcription

Contents

Example

Case A

  • Consider one unit of investment that costs $1,000 and returns $1,100 at the end of year 1, i.e. a 10% return on investment before taxes.
  • Now assume tax rate of 20%.
  • If an investor pays $1,000 of capital, at the end of the year, he will have ($1,000 return of capital, $100 income and –$20 tax) $1,080. He earned net income of $80, or 8% return on capital.

The concept was originally added to the methodology proposed by Franco Modigliani and Merton Miller for the calculation of the weighted average cost of capital of a corporation.

Case B

  • Consider the investor now has an option to borrow $4,000 at 8% interest rate.
  • If the investor still pays $1,000 of his initial equity capital, in addition to borrowing $4,000 at the terms above, the investor can purchase 5 units of investment for $5000 total.
  • At the end of the year, he will have: ($5,000 return of capital, $500 revenue (due to the 10% return on each unit of investment), –$4,000 repayment of debt, –$320 interest payment, and $(500-320)*20%= $36 tax). Therefore, he is left with $1,144. He earned net income of $144, or 14.4% return on his $1000 initial equity capital.

The reason that he was able to earn additional income is because the cost of debt (i.e. 8% interest rate) is less than the return earned on the investment (i.e. 10%). The 2% difference makes income of $80 and another $100 is made by the return on equity capital. Total income becomes $180 which becomes taxable at 20%, leading to the net income of $144.

Value of the Tax Shield

In most business valuation scenarios, it is assumed that the business will continue forever. Under this assumption, the value of the tax shield is: (interest bearing debt) x (tax rate).

Using the above examples:

  • Assume Case A brings after-tax income of $80 per year, forever.
  • Assume Case B brings after-tax income of $144 per year, forever.
  • Value of firm = after-tax income / (return of capital), therefore
  • Value of firm in Case A: $80/0.08 = $1,000
  • Value of firm in Case B: $144/0.08 = $1,800
  • Increase in firm value due to borrowing: $1,800 – $1,000 = $800
  • Alternatively, debt x tax rate: $4,000 x 20% = $800;

See also

References

  1. ^ a b Kemsley, Deen; Nissim, Doron (October 2002). "Valuation of the Debt Tax Shield" (PDF). The Journal of Finance. 57 (5): 2045–2073. doi:10.1111/0022-1082.00488. Retrieved 25 March 2013.

External links

This page was last edited on 2 November 2017, at 16:50
Basis of this page is in Wikipedia. Text is available under the CC BY-SA 3.0 Unported License. Non-text media are available under their specified licenses. Wikipedia® is a registered trademark of the Wikimedia Foundation, Inc. WIKI 2 is an independent company and has no affiliation with Wikimedia Foundation.