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 increases the value of the business, and it is an important aspect of business valuation.

Example

Case A

The concept was originally added to the methodology proposed by Franco Modigliani and Merton Miller for the calculation of the weighted average cost of capital of a corporation.

Case B

The reason that he was able to earn additional income is because the cost of debt (i.e. 8% interest rate) is less than the return earned on the investment (i.e. 10%). The 2% difference makes income of $80 and another $100 is made by the return on equity capital. Total income becomes $180 which becomes taxable at 20%, leading to the net income of $144.

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 bearing debt) x (tax rate). Using the above examples: