Question

Your firm currently has

$ 88$88

million in debt outstanding with a

9 %9%

interest rate. The terms of the loan require the firm to repay

$ 22$22

million of the balance each year. Suppose that the marginal corporate tax rate is

30 %30%​,

and that the interest tax shields have the same risk as the loan. What is the present value of the interest tax shields from this​ debt?

Answer 1

Interest Tax Shield :- Interest tax shield means the tax benefit received due to the payment of interest expenses on debts. Interest expenses are tax-deductible expense because interest expenses reduce taxable profits of a company and thereby help in reduction of corporate tax liability.

Let's understand the concept of interest tax shield with an example.

A company has EBIT of $10,000 and interest expenses amount to be $2,000 and a corporate tax rate of 30% is applicable. After deducting interest expenses from the EBIT, company's EBT would be $8,000 ($10,000 - $2,000). Now, the tax that the company is liable to pay would be 30% of $8,000, i.e., $2,400.

Now, suppose that there is a similar situation but without interest expenses. So, company's EBT would be $10,000 because there are no interest expenses. Now, the tax that the company is liable to pay would be 30% of $10,000, i.e., $3,000, which is $600 (or, $30% of $2,000) more than the tax payable in the first scenario. This happened due to the absence of interest expenses. This $600 is the interest tax shield in the first scenario.

In the question given above,

Debt Outstanding = $88,000,000

Debt Payable in four equal annual installments of $22,000,000.

Interest Rate = 9% per annum

Tax Rate = 30%

Using this information we can prepare the following interest expenses table.

This table shows interest expenses to be paid at the end of each year and the amount of debt outstanding at the end of each year.

To calculate the interest tax shield, we can use the following formula.

Interest Tax Shield = Debt Outstanding * Interest Rate * Tax Rate

Using the above formula, I have calculated the interest tax shield for each year as shown in the table below.

Now, to calculate the present value (PV) of interest tax shields, we can use the following formula:

where, n = number of years

For the question given, we have to calculate PV of tax shield available in each year from year 1 to year 4.

Following table shows the PV of interest tax shields for each year and the total of PV of interest tax shields.

Therefore, the present value of the interest tax shields from this debt = $5,017,849.