Tax Shield Formula (Table of Contents)
What is the Tax Shield Formula?
A Tax shield is a necessary reduction in an individual or corporation’s taxable income achieved when a huge amount of expenses incorporate with total income, such as mortgage interest: medical expenditure, charitable donation, and depreciation. Tax shields vary from country to country and based on which deductions are defined, whether it is legitimate or not. The value of the tax shield depends on the effective tax rate for the corporation or individual. There may be several other cases where the current year’s income can be lowered than the previous year due to unclaimed tax losses of the previous years.
Basically, the company uses two main tax shield strategies.
- Capital structure optimization.
- Accelerated depreciation methods.
1. Capital Structure: The impact of adding/ removing a tax shield is highly impacted by the company’s optimal capital structure, which is a mix of debt and equity funding. Moreover, the interest expense on the debt is tax deductible which makes the debt funding cheaper.
2. Accelerated Depreciation: The depreciation expense is tax-deductible, where companies try to maximize the depreciation expenses, so they can readily incorporate tax filings. Corporations use various other depreciation methods such as double declining balance and sum of years – digits to lower taxes in the early years.
To further increase the cash flows and value of the business, tax shields are majorly used. Where the formula can determine the effect of the tax shield as such:
Examples of Tax Shield Formula (With Excel Template)
Let’s take an example to understand the calculation of Tax Shield in a better manner.
Tax Shield Formula – Example #1
Assume a firm with a Sales revenue of 1,000, a Cost of goods sold, COGS of 500, a Financial Expenses FE, of 200 and a corporate tax rate of 30%. if we add financial expenses that what will be the final outcome?
Solution:
Here is a representation of total outcome in tabular format, where taxes are calculated as:
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TS = E (bt) * T
When the firm does not meet the Full TS as mentioned in the above calculation, then we firm follows either of the below-mentioned conditions:
Table Shields when EBIT + OI > FE
When we increase FE from 0 to 150, in that case, net income decreases from 120 to 30, and the net reduction is 90, and TS remains the same 60. When EBT falls down to zero or negative, in that situation, the firm doesn’t pay anything.
Table Shields when EBIT + OI < FE
Here, we have used the EBIT = 100, and FE is risen up from 0 to 150, But net income drops down to -50 from 60, which becomes 110, and TS remains as 40. In such a situation, it doesn’t pay taxes. Hence, Tax shields are not corporate tax rate times financial expenses.
In these criteria, Tax shields are corporate tax rate times EBIT plus other income. When EBIT + IO < 0, Tax shields are zero.
Explanation
Tax Shield defines the additional expense on the bottom line as reduced. At certain condition tax expense E(at) becomes E (bt) x (1-T). Hence
E(at) = E (bt) x (1-T)
TS = E (bt) x T
When the above-mentioned formula doesn’t meet the condition, Then EBIT(adj) plays a vital
Case 1: TS when EBIT(adj) >= FE when taxes are paid in the same period, and interest payments are the only source of TS.
Case 2: 0< EBIT(adj)< FE, when the firm doesn’t pay taxes and has no debt
Case 3: EBIT(adj) < 0, when EBIT(adj) is negative,the TS are zero
Where,
- EBIT = Earnings Before Interest and Tax
- EBIT(adj) = Earnings Before Interest and Tax Amount Offset Against Fe.
- FE = Financial Expences
- T = Corporate Tax
- TS = Tax Shield
Relevance and Use of Tax Shield Formula
Tax Shield minimizes the tax bills; it is the only reason why taxpayer, either individual or corporation, spend a considerable time determining how much tax levy or credit every year.
There are certain benefits of the tax shield strategy as such:
- Reduce the taxpayer’s taxable income for a given year or impose deferring income tax into future periods. In a similar way, we save the cash flows and increases the value of a firm.
- The strategy by which we minimize tax liability and increases the value of a business.
- It is the only way by which we can save cash outflows and appreciate the value of a firm. Tax shield in various other forms involves the type of expenditure that is deducted straight away from taxable income.
- A tax shield is the future tax saving attribute of tax by determining the firm’s present value and helps to predict the deductibility of a particular expenditure in the profit & loss account.
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