Tax Shield

Tax Shield

"A reduction in taxable income for an individual or corporation achieved through claiming allowable deductions such as mortgage interest, medical expenses, charitable donations, amortization and depreciation. These deductions reduce taxpayers' taxable income for a given year or defer income taxes into future years.

Tax shields vary from country to country, and their benefits will depend on the taxpayer's overall tax rate and cash flows for the given tax year."

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To make it simple, let's take a look at this illustration :

We can see the different tax payed (75) by these firms with/without debt for its capital structure, it called tax shield. Some said that firm with debt financing is good. Debt financing can amplify the effects of changes in operating income on the returns to stockholders (financial leverage), we can see from ROE above Net Income/Equity. But debt also increases financial risk and causes shareholders to demand a higher return on their investment, like MM's proposition II  "The required rate of return on equity increases as the firm’s debt-equity ratio increases" because of debt interest itself. All equity financing also has their own risk because shareholder absorb all of the firm's risk. 

Capital structure does not necessarily affect firm value. Modigliani and Miller’s (MM’s) famous debt-irrelevance proposition states that firm value can’t be increased by changing  capital structure. Therefore, the proportions of debt and equity financing don’t matter.  Financial leverage  does increase the expected rate of return to shareholders, but the risk of their shares increases proportionally. MM show that the extra return and extra risk balance out, leaving shareholders no better or worse off. 

So,  Is there a rule for finding optimal capital structure? Sorry, there are no simple answers for capital structure decisions. Debt may be better than equity in some cases, worse in others. But there are at least four dimensions for the financial manager to think about.    

• Taxes, How valuable are interest tax shields? Is the firm likely to continue paying taxes over the full life of a debt issue? Safe, consistently profitable firms are most likely to stay in a taxpaying position.    
• Risk, Financial distress is costly even if the firm survives it. Other things equal, financial distress is more likely for firms with high business risk. That is why risky firms typically issue less debt.     
• Asset type, If distress does occur, the costs are generally greatest for firms whose value depends on intangible assets. Such firms generally borrow less than firms with safe, tangible assets.     
• Financial slack, How much is enough? More slack makes it easy to finance future investments, but it may weaken incentives for managers. More debt, and therefore less slack, increases the odds that the firm may have to issue stock to finance future investments.     

References : 

Richard A. Brealey, Stewart C. Myers, Alan J. Marcus. 2012. Fundamentals of Corporate Finance, 7th ed. McGraw-Hill.  

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