Tax shields

CFA Level I FRA
#1

When is a company most likely to use debt financing?

I.) A high degree of business risk

II.) Little shielded taxable income

III.) When it seeks financial flexibility

IV.) When it has conservative management

The answer is II.

Unfortunately, Reading 36 doesn’t seem to go into tax shields that much even though this question is from Reading 36. However, it seems that tax sheilds are tax deductions based on costs that are deducted in order to arrive at taxable income. It seems to me that if a company has little shielded taxable income, taxes are low. Therefore, there would be little incentive to use debt financing because the tax deductions wouldn’t be worth it. The answer makes it sound as if tax shields are treated as credits, and can be applied to costs across the board. The rationale behind the answer is:

“if a firm has little or no used shields, there is reason to finance with debt because of interest cost tax deductability” Any help would be greatly appreciated.

#2

This is very straightforward:

Interests from debt are (in most jusristictions) tax deductible. Hence, debt lowers taxable income (as per answer II) and consequently lowers imcome taxes.

Basically, the fact that interests are tax deducticle lowers the real cost of debt by t x i. This is the reason why you multiply the cost of debt with the term (1-t) to get the after tax cost of debt when deriving the WACC.

Best, Oscar

#3

Thanks for the response.

I understand the concept of deductions based on interest expense, so perhaps I’m misunderstanding the wording of the question. The company is most likely to use debt financing when it can generate large tax deductions, but the question almost makes it sound as if they currently have little income subject to tax shields (i.e. deductions) so if that is the case, they wouldn’t stand to gain much in terms of tax deductions on new debt.