Interest Tax Shields

Using interest expense to lower taxes

What are Interest Tax Shields?

The interest tax shield refers to the reduced income taxes brought about by deductions to taxable income from a company’s interest expense. For instance, there are cases where mortgages may have an interest tax shield for buyers since the mortgage interest is deductible against income.  Interest tax shields encourage firms to finance projects with debt, since the dividend to equity investors are not deductible.

Among corporations/firms, one of the main objectives is to reduce their tax liability as much as possible.


interest tax shield theme


Valuation of the Interest Tax Shield

In the valuation of the interest tax shield, it capitalizes the value of the firm and second it also limits the tax benefits of the debt. Interest expenses are considered to be as tax deductibles and thus tax shield is very important as firms can get benefits from the structuring of such arrangement. The interest tax shield if positive when the EBIT is greater than the interest payment. It is also important to keep in mind that the interest tax shield value is the present value of the all the interest tax shields.


Tax Shield for Individuals

Individuals can also take advantage of the tax shield. This is very useful especially when you want to purchase a home with a loan or a mortgage. In getting a house with a mortgage, the interest expenses are tax deductible which means that the person can get benefits from it as it can offset against his or her taxable income. As a result, you can reduce tax liability. This is definitely a good benefit especially for people who want to get a home and would want to lessen their tax liability.

Following the basic concept of a tax shield, it is important to understand how it works as it is considered to be an essential part of the business valuation. Each country varies when it comes to the interest tax shield that individuals and business can get. In the end, the benefits would still depend on the cash flow and the overall tax rate of the taxpayer. Governments provide interest tax shields in order to encourage more investments for companies and firms as well as for individuals


Additional resources

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