The term "Tax Shield" refers to the deduction allowed on the taxable income that eventually results in the reduction of taxes owed to the government. The formula for tax shields is very simple, and it is calculated by first adding the different tax-deductible expenses and then multiplying the result by the tax rate.
Mathematically, it is represented as,
Tax Shield formula = Sum of Tax-Deductible Expenses * Tax rate.
Although tax shield can be claimed for a charitable contribution, medical expenditure, etc., it is primarily used for interest and depreciation expenses in a company. Therefore, the tax shield can be specifically represented as tax-deductible expenses.
The calculation of interest tax shield can be obtained by multiplying average debt, cost of debt and and tax rate as shown below,
Interest Tax Shield Formula = Average debt * Cost of debt * Tax rate.
The calculation of depreciation tax shield can be obtained by depreciation expense and tax rate as shown below,
Depreciation Tax Shield Formula = Depreciation expense * Tax rate
The tax shield can be calculated by using the following steps:
Let us consider an example of a company XYZ Ltd, which is in the business of manufacturing synthetic rubber. As per the recent income statement of XYZ Ltd for the financial year ended on March 31, 2018, the following information is available. But, first, do the calculation of Tax Shield enjoyed by the company.
Based on the information, do the calculation of the tax shield enjoyed by the company.
The following is the Sum of Tax-deductible Expenses,
Therefore, the calculation of Tax Shield is as follows,
The Tax Shield will be -
Tax Shield= $12,000
Therefore, XYZ Ltd enjoyed a Tax shield of $12,000 during FY2018.
Let us take the example of another company, PQR Ltd., which is planning to purchase equipment worth $30,000 payable in 3 equal yearly installments, and the interest is chargeable at 10%. The company can also acquire the equipment on lease rental basis for $15,000 per annum, payable at the end of each year for three years. The original cost of the equipment would be depreciated at 33.3% on the straight-line method. The applicable tax rate is 35%. Determine which option is more viable for the company. Purchase of Equipment on Debt or Purchase of Equipment on Lease.
1 st option (Purchase of Equipment on Debt)
Annual repayment=Equipment price * Interest rate * /
= $30,000 * 10% * ÷ = $12,063
Cash Outflow in Year 1 = Annual repayment – Depreciation tax shield – Interest tax shield
= $12,063 - $30,000 * 33.3% * 35% - $30,000 * 10% * 35% = $7,513
Cash outflow in year 2 = $12,063 - $30,000 * 33.3% * 35% - ($30,000 - $12,063 + $3,000) * 10% * 35%
Cash outflow in year 3 = $12,063 - $30,000 * 33.3% * 35% - ($20,937 - $12,063 + $2,094) * 10% * 35%
PV of cost of acquisition @10% = $7,513 / (1+10%) + $7,831 / (1+10%) 2 + $8,180 / (1+10%) 3
2 nd option (Purchase of Equipment on Lease)
PV of cost of acquisition @10% = $9,750 / (1+10%) + $9,750 / (1+10%) 2 + $9,750 / (1+10%) 3
Therefore, the 1 st option is better since it offers a lower cost of acquisition.
You can use the following tax shield calculator.
The tax shield is a very important aspect of corporate accounting since it is the amount a company can save on income tax payments by using various deductible expenses. These savings eventually add to the Company's bottom line. The higher the savings from the tax shield, the higher the company's cash profit. The extent of tax shield varies from nation to nation, and their benefits also vary based on the overall tax rate.
This has been a guide to the Tax Shield Formula. Here we discuss calculating depreciation and interest tax shield for the company, along with the practical examples and a downloadable excel sheet. You can learn more about financing from the following articles –
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