Capital structure and payout
The interest tax shield
Value the tax saved by deducting interest, and weigh it against the expected cost of financial distress.
Learning objectives
- Calculate the annual interest tax shield and its present value
- Value the tax shield of permanent and of fixed-term debt
- Find the debt level that maximises value when distress costs rise with leverage
Interest is deductible for tax in most systems; dividends are not. So every riyal of interest a company pays reduces its tax bill by t riyals. That saving, the interest tax shield, is the main reason debt can add value.
If debt is so valuable, why not borrow as much as possible? Because more debt raises the chance of financial distress: missed payments, lost customers and suppliers, fire sales of assets, and legal costs. The trade-off theory says the best capital structure balances the PV of the tax shield against the expected PV of distress costs.
Annual shield = t × Kd × D PV (permanent debt) = t × D V_L = V_U + PV(tax shield) − PV(distress costs)
- t
- tax rate (illustrative)
- Kd × D
- annual interest; shields are discounted at Kd, because they are as risky as the debt
- V_U
- value of the company with no debt
- V_L
- value with debt
Included with a Formula Quest membership
The rest of this lesson is for members. Members get the full lesson, including its 3 graded exercises, and every other Finance Quest lesson.