Question

“The interest tax shield plays a key role in the WACC valuation framework”.
Discuss
(maximum 300 words – you can refer to the interest tax shield as the ITS in your answer)

5 Marks

Answer 1

Weighted average cost of capital will be reflecting the cost of capital after ascertainment of various type of capital which are included in the overall capital structure of the organisation and debt capital is one of the most important capital which will be included in the overall capital structure and debt capital will generally be known for providing with the interest tax shield.

Interest tax shield will be resulting out of tax deduction which has been provided on payment of the interest because when we are trying to include the debt capital in the overall capital structure then, Debt capital will generally be having a fixed repayment in the form of the interest and interest charged is not taxable and there is a tax deduction associated with the interest payments and hence it will be helpful in order to lower the overall cost of capital of the company as it will be lowering the cost of the debt of the company and it will also be lowering the cost of overall capital of the company so it will be leading to higher growth and higher profits of the company because interest rate tax shield are resulting out of tax benefits which are provided on payment of interest as interest are tax deductible in nature.

When we are valuing the debt capital in weighted average cost of capital then we will be trying to find out the product of the cost of the debt along with the weight of the debt and we will be trying to multiply debt cost with (1-rax rate) so that we can find the after-tax cost of debt because interest payments which are payable on debt capital are tax deductible in nature and it will be lowering the overall cost of debt and it will eventually lead to lowering up with the overall cost of capital and it will help the company in maximizing the rate of return because their cost of capital will be lowered and it will also help the company to grow as the cost of capital has been lowered due to interest tax benefit associated with the capital.