The term “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.
One of the main objectives of companies is to reduce their tax liability as much as possible. Interest tax shields encourage firms to finance projects with debt since the dividends paid to equity investors are not deductible.
Valuation of the Interest Tax Shield
In the valuation of the interest tax shield, it capitalizes the value of the firm, and it also limits the tax benefits of the debt. Interest expenses are considered to be tax-deductible, so tax shields are very important, as firms can get benefits from the structuring of such arrangements.
The interest tax shield is 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 all the interest tax shields.
Tax Shield for Individuals
Individuals can also take advantage of the tax shield. It is very useful 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 their taxable income. As a result, you can reduce tax liability.
It is important to understand how an interest tax shield works, as it is considered to be an essential part of business valuation. Each country varies when it comes to the interest tax shield that individuals and businesses can get. In the end, the benefits 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.
Thank you for reading CFI’s guide to Interest Tax Shields. To continue learning and advancing your career, see the following CFI resources:
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