I found this answer in one of the Qbank questions but I am trying to understand why it is the amount of debt rather than the amount of interest payments on that debt?
The value of a tax shield is equal to the marginal tax rate times the amount of debt in the capital structure.
i.e. tax shield is created because interest of debt is tax deductible so wouldn’t we use the total amount of interest paid rather than the portion of debt?
Thanks in advance.
So to actually understand this better, assume the following:
EBIT - 100 EBIT - 100
Interest - 10 interest - 0
Tax rate 30% both scenarios.
Now if you work the math out, in scenario 1 with debt, you’re paying 27 bucks in taxes due to lower taxable income against paying 30 bucks in scenario 2 due to no debt. You’re saving 3 bucks in taxes by just taking on debt. Hence, when u actually calculate FCF, you can do it like this:
NI + NCC + (Interest - Taxes saved due to interest) - Capex - Wcinv.
Hope this helps.
Also, remember that every expense on the income statement causes a tax shield.
Thank you very much for the explanation - makes sense now!
@saurab, why didn’t you use a debt ratio (capital structure) in your explanation?
The point is see how a tax shield comes up by just taking on leverage (regardless of the capital structure). You can take any debt ratio to see how much a company would be saving on its taxes. Consider running a sensitivity analysis on Excel to better understand.