Tax Shield | Formula| Example | Definition | Calculation

Tax Shield | Formula| Example | Definition | Calculation – Tax Shield is the saving in taxable income for Corporations / Individuals by deducting allowable expenses such as Interests, Depreciation, Hospital Expense etc. Tax Shield has become an important part of decision making process in Project Finance / Corporate Finance.

In this article, we look at Tax Shield in detail –

What is Tax Shield?


Tax shield is a reduction in taxable income for an individual or corporation achieved through claiming allowable deduction such as mortgage interest, medical expenditure, charitable donation, amortisation and depreciation.

  • This income reduce taxpayer’s taxable income for a given year or defer income taxes into future periods. It is a way to save cash flows and increase the value of a firm.
  • The Tax shield strategy can be used to increase the value of a business, since it reduces the tax liability that would otherwise reduce the value of the entity’s assets.
  • Tax shields is a path to save cash outflows and appreciate the value of a firm. Tax shield in the way of various forms involves in types of expenditure that is deductible from taxable income.
  • In simple words a tax shield is the present value of future tax saving attributes to the tax to the tax deductibility of a particular expenditure in Profit and Loss Account.

What is the Importance of tax shield?


Tax shield lower tax bills, which is one of the major reason why taxpayers whether individual or corporation spend a considerable amount of time determining which deduction and credits they qualify for each year.

Benefits of Tax shield


There are various items/expenses whether it is cash or non cash on which an Individual or Corporation claims the tax shield benefits.

The followings are some of the cases:

  • Tax Shield on Depreciation
  • Tax Shield on Interest
  • Tax Shield for Individuals

Tax shield on Depreciation


  • Tax shield on depreciation is the proper management of assets for saving the tax. A depreciation tax shield is a tax reduction technique under which depreciation expenses is subtracted from taxable income.
  • This is a non cash item but we get deduction from our taxable income. This will become a major source of cash inflow which we saved by not giving tax on depreciation amount.
  • It’s just like a provision we creates every year in respect of its capital expenditure.

Tax Shield Calculation on Depreciation Example

A company is reviewing an investment proposal in a project involving as capital outlay of $90,00,000 in a plant and machinery. The project would have a life of 5 years at the end of which the plant and machinery could fetch value of $30,00,000.

Further the project would also need a working capital of $ 12,50,000 which would be built during the year 1 and to be released from the project at  the end of year 5. The project is expected to yield the following cash profits:

Year 1 2 3 4 5
Cash profits ($ ) 35, 30 25 20 20

A 25 % depreciation for plant and machinery is available on accelerated depreciation basis as Income tax exemption. Assume that the corporate tax is paid one year in arrear of the periods to which it relates and the first year’s depreciation allowance, would be claimed against the profits of year 1.

The Management accountant has calculated Net Present Value (NPV) of the project using company’s corporate target of 20 % pre-tax rate of return and has considered the taxation effect in the cash flows. The project’s cash flows should incorporate the effects of tax. The corporate tax is expected to be 35 % during the life of the project and thus the company’s rate of return post-tax is 13 % (20 % * 65 %).

Required:

  1. To calculate post tax cash flow at a post-tax rate.
  2. Calculate the net present value (NPV) of the project taking the tax shield formula into consideration.
Tax on cash profit ($ in ‘00,000s)
Year of profit Cash profit Tax@35 % Year of tax payment
1 35 12.25 2
2 30 10.50 3
3 25 8.75 4
4 20 7.00 5
5 20 7.00 6
Depreciation Allowances- Tax Rebate ($ in ‘00,000)
Year Reducing Balance Depreciation@ 25 % Tax rebate/ ( Tax payable) 35 % on depreciation Year of cash flow
0 90.000 0 0 0
1 67.500 22.500 7.875 2
2 50.625 16.875 5.906 3
3 37.969 12.656 4.430 4
4 28.476 9.492 3.322 5
5 21.357 7.119 2.492 6
Profit on sale of Plant and machinery (30.000 – 21.357) (8.643) (3.025) 6
Calculation of NPV of the project ($ in ‘00,000)
Year Investment Depreciation allowance tax saved Cash profits Tax on profits Net cash flow Discounting factor at 13 % Present Value
Plant and Machinery Working Capital
0 (90) 0 0 0 0 (90) 1.00 (90)
1 0 (12.5) 0 35 0 22.50 0.88 19.8
2 0 0 7.875 30 (12.25) 25.63 0.78 19.99
3 0 0 5.906 25 (10.50) 20.41 0.69 14.08
4 0 0 4.430 20 (8.75) 15.68 0.61 9.56
5 30 12.5 3.322 20 (7.00) 58.82 0.54 31.76
6 0 0 (0.533)* 0 (7.00) (7.5) 0.48 (3.62)
Net Present Value 1.57
  • * (3.025) + 2.492 = (0.533)

Tax shield on Interest


Interest Shield in case of company or corporations

One of the major important objective of a corporation or firm or organisation is to reduce its tax liability for which he has to compute

  1. The tax advantage of debt.
  2. Computing the interest tax shield.

Valuation of interest tax shield.

  1. Capitalize or Recapitalize the value of firm.
  2. Limits on the tax benefits of the debt.

Interest expenses is, as opposed to dividends and capital gains, tax deductible, therefore the tax shield is an important factor. These are the tax benefits derived from creative structuring of a financial arrangement. The tax shield on interest is positive when earnings before interest and taxes i.e. EBIT exceeds the interest payment. The value of the interest tax shield is the present value i.e. PV of all future interest tax shields. Also the value of a levered firm or organisation exceeds the value of an else equal unlevered firm or organisation by the value of the interest tax shield. Lease option is one of the live example for utilization of tax shield.

Interest Tax Shield Calculation Example

 ABC Ltd. is considering a proposal to acquire a machine costing $ 1,10,000 payable $ 10,000 down and balance payable in 10 equal installments at, the end of each year inclusive of interest chargeable at 15 %. Another option before it is to acquire the asset on a lease rental of $ 25,000 per annum payable at the end of each year for 10 years. The following information is also available below. Present value factor of 15 % for 10 years is 5.019.

  1. Terminal scrap value of $ 20,000 is realizable, if the asset is purchased.
  2. The company provides 10 % depreciation on straight line method on original cost.
  3. Income tax rate is 50 %.
  4. You are required to compute and analyse cash flow and to advise as to which option is better.
Option 1 – Buy

Working notes:

  1. In this option the firm has to pay $ 10,000 down and the balance $ 1,00,000 together with interest @ 15 % is payable in 10 equal installments. The annuity amount may be calculated for 10 years at 15 % as i.e.,

Annual repayment = $ 1,00,000/5.019 = $ 19925.

  1. Discounting rate : we can use the after tax cost of debt as discounting rate for both options. We can also use the borrowing rate as weighted average cost of capital (WACC) and assume that this proposal is already considered in the calculation of weighted average cost of capital (WACC). We therefore assume that the firm’s WACC is 15 %( the borrowing rate is given above).

Since we have to use the same rate for leasing and borrowing option; there will be no change in final decision, though answers would be different.

  1. Depreciation of 10% i.e. $ 11,000 ($ 1,10,000 * 10 %) has been provided for all the years.
  2. The asset is fully depreciated during its life of 10 years, therefore, the book value at the end of 10th year would be zero. As the asset is having salvage value of $ 20,000, this would be capital gain, and presuming it to be taxable at the normal rate of 50 %, the net cash inflow on account of salvage value would be $ 10,000 only i.e. ($ 20,000 * 50 %). This is further discounted to find out the present value of this inflow.

The cash flow of the interest in the purchase option may be calculated as follows:

( Amount in $ )

A B C =15 % D = B-C E
Year Instalment ($) Interest ($) Repayment ($) Balance ($)
0 1,00,000
1 19,925 15,000 4925 95,075
2 19,925 14,261 5,664 89,411
3 19,925 13,412 6,513 82,898
4 19,925 12,435 7,490 75,408
5 19,925 11,311 8,614 66,794
6 19,925 10,019 9,906 56,888
7 19,925 8,533 11,392 45,496
8 19,925 6,824 13,101 32,395
9 19,925 4,859 15,066 17,329
10 19,925 2,596 17,329 0.00

The Present value of cash outflows may now be found as follows:

( Amount in $)

Year Payment Interest Depreciation Tax shield 50 % Net cash flow Present value factor (15 %n) Present value
1 2 3 4 5 = (3+4) * 50 % 6 = (2-5) 7 8
0 10,000 0 0 0 0 0 10,000
1 19,925 15,000 11,000 13,000 6,925 0.870 6,025
2 19,925 14,261 11,000 12,631 7,294 0.756 5,514
3 19,925 13,412 11,000 12,206 7,719 0.658 5,079
4 19,925 12,435 11,000 11,718 8,207 0.572 4,694
5 19,925 11,311 11,000 11,156 8,769 0.497 4,358
6 19,925 10,019 11,000 10,510 9,415 0.432 4,067
7 19,925 8,533 11,000 9,767 10,158 0.376 3,819
8 19,925 6,824 11,000 8,912 11,013 0.327 3,601
9 19,925 4,859 11,000 7,930 11,995 0.284 3,407
10 19,925 2,596 11,000 6,798 13,127 0.247 3,242
Present value of total cash outflows – (A) 53,806
Salvage value ( after tax ) – (B) 10,000 0.247 2,470
Net present value of cash outflows – (C) = (A) + (B) 51,336
Option II – leasing

Evaluation of Lease option. – In case, the asset is acquired on lease, there is an annual lease rent of $ 25,000 payable at the end of next 10 years. This lease rental is tax deductible; therefore, the net cash outflow would be only $ 12,500 i.e. ( $ 25,000 * 50 % ).  The present value annuity factor for 10 years at the rate of 15 % is already provide above i.e. 5.019.

So, the present value of annuity will be calculated as $ 12,500 * 5.019 = $ 62738.

By comparing the above two option calculated  we came to the conclusion that the present value in case of buying by taking tax shield is lower than the lease option.

Therefore it is advisable to go for the buying option (go for lower expense)

Tax Shield for Individuals


One of the best illustration of tax shield strategy for an Individual is to acquire a home with a mortgage or loan. The interest expenses associated with the mortgage or loan is tax deductible, which then offset against the taxable income of the person, resulting in a significant reduction in his or her tax liability. The ability to use housing loan as a tax shield is a major benefit for middle class people whose houses are major components of their net worth. It also makes beneficiary to those who are interested in purchasing of house, by providing a specific tax benefits to the borrower.

Tax Shield Example for Individual

Suppose a cash outflow, interest or salary expenses, is $ 1,000/- and rate of income tax is 30 percent. So the cash outflow which will consider for discounting would be

$ 700/- i.e. $ 1000* (100-30) %.

  • Tax shield on Medical expenditure- The taxpayers who have paid more in medical expenses than covered by the standard deduction can choose to itemize in order to gain a huge tax shield.
  • Tax shield on Charity- Charitable giving can also lower a taxpayer’s obligations. In manner to qualify, the taxpayer must use itemised deductions on his tax return. 

Finally we conclude on account of above stated cases that tax shield can be utilised as valuable option for effective evaluation of cash flow, financing etc. activities.

Conclusion


So what we needs to be understood is tax shields is an important aspect of business valuation and vary from country to country, and their benefits depend upon  the taxpayer’s  overall tax rate and cash flow for the given tax year. Governments often create tax shield as a way to encourage certain behavior or investment in certain industries or programs.

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