Tax shield

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A tax shield is the reduction in income taxes that results from taking an allowable deduction from taxable income. For example, because interest on debt is a tax-deductible expense, taking on debt creates a tax shield. Since a tax shield is a way to save cash flows, it is an important aspect of business valuation.

Example
Case A
Consider one unit of investment cost $1,000 and returns $1,100 at the end of year 1. Assume tax rate of 20%. If an investor pays $1,000 of capital, at the end of the year, he will have ($1,000 return of capital, $100 income and -$20 tax) $1,080. He earned net income of $80, or 8% return on capital.

Case B
Consider the investor has an option to borrow $4000 at 8% interest (same rate as return of capital in Case A). By borrowing $4,000 (+$1,000 capital), the investor can purchase 5 units of investment. At the end of the year he will have ($5,000 return of capital, -$4,000 repayment of debt, $500 revenue, -$320 interest payment and -$36 tax)considering $1000 initial capital he is left with $1,144. He earned net income $144, or 14.4%.

The reason that he was able to earn additional income is because the cost of capital (opportunity cost, 8%) is not deductible for tax purposes, but the cost of debt (interest, 8%) is.

Value of the Tax Shield
In most business valuation scenarios, it is assumed that the business will continue forever. Under this assumption, the value of the tax shield is: interest on debt x tax rate.

Using the above examples:
Assume Case A brings $80 after tax income per year, forever.
Assume Case B brings $144 after tax income per year, forever.

Value of firm in Case A: $80/0.08 = $1,000
Value of firm in Case B: $144/0.08 = $1,800
Increase in firm value due to tax shield: $1,800 - $1,000 = $800

Debt x tax rate: $4,000 x 20% = $800