Tax Shield

What is Tax Shield?

Tax 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 and is calculated by multiplying the deductible expense for the current year with the rate of taxation as applicable to the concerned person.

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

  • This income reduces taxpayer’s taxable income for a given year or defers income taxes into future periods. It is a way to save cash flows and increase the value of a firm.
  • This 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.
  • They are 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.

Tax-Shield-Formula

Why is it Important?

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

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

Tax shield on Depreciation

  • A 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 are subtracted from taxable income.
  • This is a noncash item, but we get a 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 create 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 a 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 a value of $30,00,000.

Further, the project would also need a working capital of $ 12,50,000, which would be built during 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 the company’s corporate target of 20 % pre-tax rate of return and has considered the taxation effect on the cash flows. The project’s cash flows should incorporate the effects of the 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 important major objectives of a corporation or firm or organization 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 the interest tax shield:

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

Interest expenses are, as opposed to dividends and capital gains, tax-deductible. Therefore the tax shield is an important factor. These are the tax benefits derived from the creative structuring of a financial arrangement. The tax shield on interest is positive when earnings before interest and taxes, i.e., EBIT, exceed 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 organization exceeds the value of an else equal unlevered firm or organization by the value of the interest tax shield. A lease option is one of the live examples.

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. The 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 a 10 % depreciation on the straight-line method on the original cost.
  3. The income tax rate is 50 %.
  4. You are required to compute and analyze 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 a discounting rate for both options. We can also use the borrowing rate as a weighted average cost of capital (WACC) and assume that this proposal is already considered in the calculation of the 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 the 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 the 10th year would be zero. As the asset is having a 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 Installment ($) Interest ($) 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
The 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 the lease. There is an annual lease rent of $ 25,000 payable at the end of the 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 a rate of 15 % is already provided 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 options calculated, we came to the conclusion that the present value in case of buying by taking a tax shield is lower than the lease option.

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

Tax Shield for Individuals

One of the best illustrations of this concept 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 a 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 the house, by providing a specific tax benefit to the borrower.

Tax Shield Example for Individual

Suppose a cash outflow, interest or salary expenses, is $ 1,000/- and the 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 the manner to qualify, the taxpayer must use itemized deductions on his tax return. 

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

Tax Shield Video

Conclusion

So what we need to be understood is tax shields are 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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Comments

  1. Avatarprit says

    Have learnt something in regards to my accounting profession.

    • AvatarDheeraj Vaidya says

      thanks Prit!

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