Capital structure and taxes

Question 1

Intuition of interest tax deduction

Answer 1

Corporations pay taxes on their profits after interest payments are deducted. Thus, interest expense reduces the amount of corporate taxes.

Question 2

Interest tax shield

Answer 2

The interest tax shield is the reduction in taxes paid due to the tax deductibility of interest.

Interest tax shield = Corporate tax rate x Interest payment

Question 3

Valuation of the interest tax shield

Answer 3

• When a firm uses debt, the interest tax shield provides a corporate tax benefit each year.
• This benefit is the computed as the present value of the stream of future interest tax shields the firm will receive.
• The cash flows a levered firm pays to investors will be higher than they would be without leverage by the amount of the interest tax shield

Cash flows to investors with leverage = Cash flows to investors without leverage + interest tax shield