The Tax Shield: Why Debt Creates Value (With Taxes)

Interactive tool for Lectures 15--16: Capital Structure and Taxes

Income Statement Inputs

Tax Shield (Annual): --
PV of Perpetual Tax Shield: --
Formula: Tax Shield = Interest × Tax Rate
Tax Shield = (Debt × rD) × tc
For perpetual debt: PV = tc × D

Side-by-Side Income Statements

All-Equity Firm
EBIT $20,000
Interest Expense $0
EBT (Earnings Before Tax) $20,000
Taxes @ [tc] $4,000
Net Income / Payout to Equity $16,000
Leveraged Firm (with Debt)
EBIT $20,000
Interest Expense $0
EBT $20,000
Taxes @ [tc] $4,000
Net Income to Equity $16,000
+ Interest Paid to Debt $0
Total Payout to All Investors $16,000

Firm Value vs Debt Level

Shows how firm value changes as you increase debt (with and without taxes)

Total Investor Payout vs Debt Amount

Higher debt increases total payout due to tax shield

Key Insight: Modigliani-Miller with Taxes (MM Proposition I)

V_Leveraged = V_Unlevered + (tc × Debt)

What this means: Firm value increases by the present value of the tax shield. With permanent debt, that's simply the tax rate times the debt amount. Every dollar of debt creates tc dollars of value.

Why? Interest is tax-deductible. When you borrow $1,000 at 10%, paying $100/year, the company saves $100 × tc in taxes every year forever. That's a perpetual cash flow worth $100/tc to the firm.

Implication: Without other costs (bankruptcy, financial distress), optimal capital structure is 100% debt! Of course, real firms don't do that (see Demo 24).