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Enterprise Valuationintermediate

The Interest Tax Shield

Because interest is tax-deductible, debt financing lowers a firm’s tax bill and so adds value. That saving is the interest tax shield, equal to the corporate tax rate times the interest expense each year. Building on Modigliani and Miller with corporate taxes, the value of a permanent, fixed level of debt is the tax rate times the debt, τc D\tau_c\, D. In an APV valuation the shield is valued explicitly, separate from operating value. The cash flow here is genuinely a tax saving, not an accounting accrual, and the rate used to discount it reflects how risky those future savings are.

Try it yourself

Adjusted present value

Value the business as if all-equity, then add the financing benefit separately: V_u = FCF₁ / (k_u − g) plus PV(tax shield) = T·D gives APV = V_u + PV(shield). The shield is the tax saved on deductible interest. More debt means a larger shield, so long as you ignore distress costs.

Adjusted present value (APV)$148.3m
$133.3mshield 10% of APVUnlevered value V_uPV(tax shield)← these two stack to APV $148.3m →
Unlevered value V_u $133.3mPV(tax shield) = T·D $15.0mAPV $148.3m
Unlevered FCF₁ (year 1)$12.0m
FCF growth g2.0%
Unlevered cost of equity k_u11.0%
Debt level D$60m
Tax rate T25%
Cost of debt k_d6.0%
The business alone is worth $133.3m. Financing with $60m of debt adds a tax shield worth $15.0m (the annual saving $0.9m = T·k_d·D, capitalised), so APV is $148.3m. The shield is 10% of the total. APV keeps these two visible; WACC would hide the shield inside a lower discount rate.
Try this

With no debt the gold block disappears and APV collapses to V_u. Push the debt slider up and watch the gold shield grow. In reality the rising chance of financial distress eventually offsets the shield, so more debt is not free value.

Reflect: APV adds the shield as a separate term, while WACC lowers the discount rate to bake the shield in. For a perpetual fixed debt level the PV of the shield is simply T·D, discounted at the cost of debt k_d. If the firm instead rebalances debt to a constant ratio, the shield carries the business risk and is discounted at k_u. Which convention fits a real company better, a fixed debt schedule or a target leverage ratio?

Why it matters

The government effectively subsidises borrowing. Every dollar of interest a firm pays trims its taxable profit, so part of the interest comes back as lower tax. The yearly saving is small, just the tax rate times interest, but capitalised over the life of the debt it can be a real chunk of value. For debt that is fixed and permanent, the maths collapses to a clean result. The shield is worth the tax rate times the amount borrowed. That is why a financing decision, not just operations, can move a firm’s value.

Formulas

Annual interest tax shield
Tax shieldt=τc×rd×Dt\text{Tax shield}_t = \tau_c \times r_d \times D_t
The tax rate tau_c times the interest paid, where interest is the cost of debt r_d on the debt level D in year t. This is the cash tax saved that year, not a charge against profit.
Value of a fixed perpetual debt shield
Vshield=τc×DV_{\text{shield}} = \tau_c \times D
When debt is permanent and discounted at the cost of debt, the present value of the shield reduces to the tax rate times the amount of debt. This is the Modigliani-Miller with-tax result.

Worked examples

Scenario

A firm holds US$200m of permanent debt at a 5 percent interest rate, facing a 30 percent corporate tax rate. What is the annual tax shield and its capitalised value?

Solution

Annual interest is 5 percent of US$200m, which is US$10m. The yearly tax shield is the tax rate times interest, 0.30 times US$10m, which is US$3m saved in tax each year. Treating the debt as permanent and discounting at the 5 percent cost of debt, the shield is worth US$3m over 0.05, which is US$60m. That equals the tax rate times the debt, 0.30 times US$200m, the Modigliani-Miller shortcut. So the financing choice adds US$60m to firm value through tax alone.

Common mistakes

  • ✗The tax shield equals the interest paid. It equals only the tax rate times interest, since the firm saves tax on the deduction, not the whole interest amount.
  • ✗The shield is a non-cash accounting item. It is a real reduction in cash tax paid, which is why it adds genuine value in an APV model.
  • ✗More debt always raises value through the shield. The tax benefit is offset at higher leverage by rising financial distress and agency costs, so value does not climb without limit.
  • ✗The shield is automatically discounted at the cost of debt. The right rate depends on how safe the future savings are, which turns on whether the debt level is fixed or moves with firm value.

Revision bullets

  • •Interest is tax-deductible, so debt creates a tax saving
  • •The annual shield is the tax rate times the interest expense
  • •For fixed permanent debt the shield is worth the tax rate times the debt
  • •The result builds on Modigliani-Miller with corporate taxes
  • •In APV the shield is valued separately from operating value
  • •Distress and agency costs offset the benefit at high leverage

Quick check

The annual interest tax shield from debt equals

For a permanent, fixed level of debt D at corporate tax rate tau, the capitalised value of the tax shield is

Connected topics

WACCCost of DebtLevered BetaEnterprise DCFAPV

Sources

  1. Modigliani & Miller (1963), AER
    Modigliani, F., & Miller, M. H. "Corporate Income Taxes and the Cost of Capital: A Correction." The American Economic Review, 53(3), 1963, pp. 433-443.
    Establishes that the tax deductibility of interest adds value equal to the tax rate times the debt.
  2. Titman & Martin, Ch. 9
    Titman, S., & Martin, J. D. Valuation: The Art and Science of Corporate Investment Decisions. Pearson.
    Treats the interest tax shield as the financing side effect valued explicitly within APV.
How to cite this page
Dr. Phil's Quant Lab. (2026). The Interest Tax Shield. Derivatives Atlas. https://phucnguyenvan.com/concept/sabv-interest-tax-shield
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