Formula to Calculate Tax Shield (Depreciation & Interest)
The term “Tax Shield” refers to the deduction allowed on the taxable income that eventually results in the reduction of taxes owed to the government. The formula for tax shield is very simple and it is calculated by first adding the different tax-deductible expenses and then multiplying the result by the tax rate.
Mathematically, it is represented as,
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For eg:
Source: Tax Shield Formula (wallstreetmojo.com)
Although tax shieldTax ShieldTax shield is the reduction in the taxable income by way of claiming the deduction allowed for the certain expense such as depreciation on the assets, interest on the debts etc. It is calculated by multiplying the deductible expense for the current year with the rate of taxation as applicable to the concerned person.read more can be claimed for a charitable contribution, medical expenditure, etc., it is primarily used for interest expense and depreciation expense in the case of a company. The tax shield can be specifically represented as per tax-deductible expenses.
The calculation of interest tax shield can be obtained by multiplying average debt, cost of debt and tax rate as shown below,
The calculation of depreciation tax shieldDepreciation Tax ShieldThe Depreciation Tax Shield is the amount of tax saved as a result of deducting depreciation expense from taxable income. It is calculated by multiplying the tax rate with the depreciation expense.read more can be obtained by depreciation expense and tax rate as shown below,
Calculation of Tax Shield (Step by Step)
The tax shield can be calculated by using the following steps:
- Firstly, gather all the tax-deductible expenses, such as interest expense, depreciation expense, charitable contribution, medical expenditure, etc., from the income statement of a company. Add all such expenses to derive the sum of all the tax-deductible expenses.
- Next, the tax rate that is applicable to the company is determined, which is dependent on the jurisdiction.
- Finally, the tax shield is calculated by multiplying the sum of tax-deductible expenses and the applicable tax rate, as shown above.
Examples
Example #1
Let us consider an example of a company XYZ Ltd, which is in the business of manufacturing synthetic rubber. As per the recent income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more of XYZ Ltd for the financial year ended on March 31, 2018, the following information is available. Do the calculation of Tax Shield enjoyed by the company.
Based on the information, do the calculation of the tax shield enjoyed by the company.
The following is the Sum of Tax-deductible Expenses,
Therefore, the calculation of Tax Shield is as follows,
- Tax Shield Formula= ($10,000 + $18,000 + $2,000) * 40%
The Tax Shield will be –
Tax Shield= $12,000
Therefore, XYZ Ltd enjoyed a Tax shield of $12,000 during FY2018.
Example #2
Let us take the example of another company, PQR Ltd., which is planning to purchase equipment worth $30,000 payable in 3 equal yearly installments, and the interest is chargeable at 10%. The company can also acquire the equipment on leaseEquipment On LeaseEquipment Lease is where the equipment owner allows another party to use it in exchange of periodic rentals with no transfer of ownership and has the right to cancel the lease right away in case of breach of the lease agreement.read more rental basis for $15,000 per annum payable at the end of each year for 3 years. The original cost of the equipment would be depreciatedEquipment Would Be DepreciatedDepreciation on Equipment refers to the decremented value of an equipment's cost after deducting salvage value over the life of an equipment. It lowers its resale value.read more at 33.3% on the straight-line method. The applicable tax rate is 35%. Determine which option is more viable for the company. Purchase of Equipment on Debt or Purchase of Equipment on Lease.
1st option (Purchase of Equipment on Debt)
Annual repayment=Equipment price * Interest rate * [(1 + Interest rate)No. of years] / [(1 + Interest rate)No. of years -1]
= $30,000 * 10% * [(1 + 10%)3] ÷ [(1 + 10%)3 -1] = $12,063
Cash Outflow in Year 1 = Annual repayment – Depreciation tax shield – Interest tax shield
= $12,063 – $30,000 * 33.3% * 35% – $30,000 * 10% * 35% = $7,513
Cash outflow in year 2 = $12,063 – $30,000 * 33.3% * 35% – ($30,000 – $12,063 + $3,000) * 10% * 35%
= $7,831
Cash outflow in year 3 = $12,063 – $30,000 * 33.3% * 35% – ($20,937 – $12,063 + $2,094) * 10% * 35%
= $8,180
PV of cost of acquisition @10% = $7,513 / (1+10%) + $7,831 / (1+10%)2 + $8,180 / (1+10%)3
= $19,447
2nd option (Purchase of Equipment on Lease)
Yearly cash outflow after tax shield = $15,000 * (1 – 35%) <<since lease rental is the only tax deductible expense, no depreciation due to lease and no interest as no debt>>
= $9,750
PV of cost of acquisition @10% = $9,750 / (1+10%) + $9,750 / (1+10%)2 + $9,750 / (1+10%)3
= $24,247
Therefore, the 1st option is better since it offers a lower cost of acquisition.
Tax Shield Calculator
You can use the following tax shield calculator.
| Sum of Tax Deductible Expenses | |
| Tax Rate | |
| Tax Shield Formula | |
| Tax Shield Formula = | Sum of Tax Deductible Expenses x Tax Rate | |
| 0 x 0 = | 0 |
Relevance and Use
The tax shield is a very important aspect for corporate accounting since it is the amount a company can save on income tax payments by using various deductible expenses, and this savings eventually adds to the bottom lineBottom LineThe bottom line refers to the net earnings or profit a company generates from its business operations in a particular accounting period that appears at the end of the income statement. A company adopts strategies to reduce costs or raise income to improve its bottom line. read more of the company. Higher the savings from the tax shield, the higher is the cash profit of the company. The extent of tax shield varies from nation to nation, and as such, their benefits also vary based on the overall tax rate.
Recommended Articles
This has been a guide to Tax Shield Formula. Here we discuss how to calculate depreciation and interest tax shield for the company along with the practical examples and downloadable excel sheet. You can learn more about financing from the following articles –
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