Tax shields are reductions in taxes that stem from a reduced taxable income. In business, interest expenses are deducted from the overall income of a corporation before it is taxed. Due to this, some theories go so far as to claim that the optimum capital structure for a corporation is 100 per cent debt. This, of course, is not the case; debt becomes more expensive to a corporation with each new issuing. At some point, the benefits of the tax shield will be outweighed by the cost of issuing new debt. Corporations, however, will issue debt up until that point.
Determine the corporate tax rate for the corporation whose tax shield is to be calculated. This can be done by looking at previous financial statements. From the income statement, divide the tax expenses by the earnings before taxes, then multiply by 100. This will express the tax rate in percentage form.
Determine the debt outstanding for the corporation whose tax shield is to be calculated. Outstanding debt can be found on the balance sheet. If the computation is simply to calculate the tax shield gained by the issuance of new debt, determine the amount of new debt that is to be issued.
Determine the interest rate on the outstanding debt, and then calculate the annual interest cost. If the calculation is for new debt being issued, determine the interest rate on the new debt.
Multiply the debt outstanding by the interest rate in that debt. This value is called interest expense and is the value that will be deducted from earnings before interest and taxes (EBIT). Remember that the total value is not the tax shield, but rather interest expense multiplied by the tax rate.
Multiply interest expense by the corporate tax rate. The resulting value is the tax shield gained from the corporation’s debt. Total interest expense less this value is the true cost of debt.
Remember that taking on debt is accompanied by an obligation to repay it on schedule.
Tips and warnings
- Remember that taking on debt is accompanied by an obligation to repay it on schedule.