Tax shield
The tax saved because interest is deductible: interest paid times the tax rate. It is why debt can lower the weighted average cost of capital, until expected distress costs outweigh it.
Where you will meet it
Tax shield appears in 5 learning outcomes on the CFA syllabus. A few of them:
- Set out what drives a firm's capital structure
“Interest is tax-deductible, so debt carries a tax shield that lowers the weighted average cost of capital — but rising leverage raises the probability and cost of financial distress.”
- Benchmark a company's cost of capital and capital structure against those of its peers
“The traps are using the debt-to-equity ratio as a weight and forgetting the tax shield.”
- Set out the Modigliani-Miller propositions and what they imply for the financing mix
“Debt now adds value through the interest tax shield, the WACC falls as leverage rises, and the theory points to all-debt financing, a conclusion that breaks down once financial distress costs are recognised.”
- Explain what target and optimal capital structures mean
“As debt rises the tax shield adds value, but the probability and cost of distress rise too.”
See also
Weighted average cost · Weighted average cost of capital
Practise it
Practise tax shield until it is automatic: questions that explain every wrong option.
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