Interest tax shield

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Interest tax shield

The reduction in income taxes that results from the tax-deductibility of interest payments.

Interest Tax Shield

A reduction in tax liability coming from the ability to deduct interest payments from one's taxable income. For example, a mortgage provides an interest tax shield for a property buyer because interest on mortgages is generally deductible. An interest tax shield may encourage a company to finance a project through debt because dividends paid on stock issues are never deductible.
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Other factors possibly altering the usability of depreciation tax shields are the alternative minimum tax and the amount of other corporate tax shields, such as interest tax shields.
Because the interest tax shields are included in the cash flows, the CCF approach is easier to apply whenever debt is forecasted in levels instead of as a percent of total enterprise value.
In that method, interest tax shields are excluded from the FCFs and the tax deductibility of interest is treated as a decrease in the cost of capital using the after-tax weighted average cost of capital (WACC).
The interest tax shields decrease taxable income, decrease taxes and, thereby, increase after-tax cash flows.
where the second terms in Equations (8) and (9) are the net interest tax shields on long-term debt.
The essential message is that if the level of debt is held constant across long- and short-term debt maturity strategies and there is no refinancing risk associated with the short-term strategy, then the expected present values of interest tax shields for the two strategies are equal.
4 They also show that long-term debt increases the debt capacity of the firm, allowing for a larger interest tax shield on debt.
Under this tax structure, there is an increase in the depreciation and interest tax shields, but it assumes the acquisition can be structured in such a way as to avoid the capital gains tax levied on the target firm.
The first column of Exhibit 2 shows the average reduction in corporate income taxes paid due to added depreciation and interest tax shields created by the leveraged buyout.
The tax incentive is the additional interest tax shield.
These relationships can take on three different forms, as shown in the three panels of Exhibit 2, depending on what is assumed about the time pattern and risk of the firm's interest tax shields.
If the firm maintains a constant debt-to-value ratio, future firm value will be perfectly correlated with the value of the operating cash flow stream, and therefore all interest tax shields beyond the first period should be discounted at r, the unlevered cost of capital.
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