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,
Although tax shield 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 shield 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:
- Step 1: 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.
- Step 2: Next, the tax rate that is applicable to the company is determined, which is dependent on the jurisdiction.
- Step 3: Finally, the tax shield is calculated by multiplying the sum of tax-deductible expenses and the applicable tax rate, as shown above.
Let us consider an example of a company XYZ Ltd, which is in the business of manufacturing synthetic rubber. As per the recent income statement 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.
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 lease 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 depreciated 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%
Cash outflow in year 3 = $12,063 – $30,000 * 33.3% * 35% – ($20,937 – $12,063 + $2,094) * 10% * 35%
PV of cost of acquisition @10% = $7,513 / (1+10%) + $7,831 / (1+10%)2 + $8,180 / (1+10%)3
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>>
PV of cost of acquisition @10% = $9,750 / (1+10%) + $9,750 / (1+10%)2 + $9,750 / (1+10%)3
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.
|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 line 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.
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 –