Interest tax shield

Definition

The interest tax shield is the reduction in taxable income that results from claiming interest payments as a tax-deductible expense. This benefit lowers the overall cost of debt for firms and can influence their capital structure decisions.

5 Must Know Facts For Your Next Test

1. Interest tax shields effectively reduce a company's tax liability by decreasing its taxable income.
2. The value of the interest tax shield is calculated as the amount of debt multiplied by the interest rate and the corporate tax rate.
3. Higher levels of debt increase the interest tax shield but also increase financial risk.
4. Interest tax shields do not apply to equity financing since dividends are not tax-deductible.
5. Firms with higher profitability and stable cash flows are more likely to benefit from utilizing an interest tax shield.

Review Questions

• How does an interest tax shield affect a firm's taxable income?
• What factors determine the value of an interest tax shield?
• Why might a firm prefer debt over equity due to the interest tax shield?

Related terms

Capital Structure:

The mix of debt, equity, and other securities that a firm uses to finance its operations.

Cost of Debt:

The effective rate that a company pays on its borrowed funds.

Corporate Tax Rate: The percentage of a corporation's profits that is paid to the government as taxes.