Interest tax shield
LBOThe tax saved because interest is deductible against taxable profit, which lowers the economic cost of debt without lowering the cash coupon.
Also written: tax shield, interest deductibility
Interest is generally deductible in computing taxable profit, so a company that pays interest pays less tax than an otherwise identical company that does not. The saving equals the tax rate multiplied by the interest expense, and it is the reason the cost of debt is normally quoted after tax.
The arithmetic is short. A 6% coupon in a jurisdiction charging 25% on profits costs the borrower about 4.5% once the deduction is taken into account. That is the right figure for comparing the cost of debt with the cost of equity, and the wrong figure for anything to do with liquidity.
The distinction is where candidates slip. The shield does not reduce the cash the company must find. The full 6% leaves the bank account on the interest date, and it comes out of the same free cash flow that would otherwise repay principal. This is why lenders test cash interest cover rather than an after tax rate, and why a business can look comfortable on an after tax cost of debt while being starved of cash.
Two conditions belong with any quotation of the shield. It is only worth the full tax rate if there is taxable profit to shelter, and a company levered hard enough may have very little. Several jurisdictions also cap the deduction at a percentage of earnings, and that cap binds hardest on the most levered borrowers, so the shield is smallest exactly where the leverage is largest.
Worked example
A borrower has 700 of debt at a 6% coupon and is taxed at 25%. Cash interest is 42 a year. The deduction saves 10.5 of tax, so the economic cost is 31.5, or about 4.5% on the balance.
Now ask what the business must actually produce. It must produce 42 of cash, not 31.5. If it generates 40 of cash before interest, it fails the cash test in that year even though the after tax cost looks modest.
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