In an ideal world, the capital structure plays no role in business valuation, at least if you follow the Modigliani-Miller theorem, which was developed in 1958 by economists Franco Modigliani and Merton Miller. According to this theory, the value of a company is determined solely by the expected cash flow and the risk of this cash flow. In practice, however, the assumptions made for this financial concept are rarely given. Insolvency costs, taxes and transaction costs are omnipresent, which means that the capital structure and the associated interest rates usually have an impact on the value of the company.
The tax shield refers to the tax advantage of debt financing due to the deductibility of interest from the tax base. By deducting interest payments on loans, a company can lower its tax burden and thus reduce its cost of capital. This leads to a tax-related increase in the value of a company through the raising of Debt. The tax shield is therefore a tax advantage for borrowing costs that can increase the value of a company.
In Germany, this generally applies in full for corporation tax and 75% for trade tax, while in many countries interest on borrowed capital is fully tax-deductible. The cash flow effect of the tax shield arises from the deduction of interest payments on loans from the taxable income base.
Auditors need a good understanding of tax regulations in order to fully assess their impact on company value. The focus here is on the tax shield, which has an impact on the WACC and cash flow and significantly influences the calculation of the beta factors.
Calculating the tax shield is relatively simple and is done by multiplying the interest rate by the tax rate. The formula is as follows:
Tax Shield=Interest payments on debt capital×tax rate\text{Tax Shield} = \text{Interest payments on debt capital} \times \text{Tax rate}Tax Shield=Interest payments on debt capital×Tax rate
For example, if a company has interest payments on debt capital amounting to EUR 200,000 and the tax rate is 30%, the tax shield is calculated as follows:
Tax Shield=200,000 Euro×0.30=60,000 Euro\text{Tax Shield} = 200,000 \, \text{Euro} \times 0.30 = 60,000 \, \text{Euro}Tax Shield=200,000Euro×0.30=60,000Euro
This means that the company achieves an annual tax saving of EUR 60,000 by using Debt instead of Equity. The value of the tax shield corresponds to the present value of all future tax savings.
The tax shield is taken into account directly in the income calculation when using the income approach. When using the DCF method, it is usually taken into account in the weighted average cost of capital (WACC) by reducing the borrowing costs by the amount of the exempt tax rate.
The formula for calculating the WACC is as follows:
Accordingly, a higher level of debt leads to a higher tax shield, which results in a lower WACC and a higher enterprise value. With the SmartZebra cost of capital module, the WACC can be calculated professionally and efficiently.
In addition to the tax shield and WACC, another parameter is relevant when assessing the influence of Debt and the associated gearing on the company value: Leverage describes the influence of debt on a company's return on equity. With the leverage effect, a higher level of debt leads to a higher proportion of borrowing costs, which can lead to a higher return on equity. This is particularly true if the expected return on the company's investments is higher than the cost of Debt.
The leverage effect can help to increase the profitability of investments by increasing the return on equity. However, it also increases risk, as higher debt also means higher interest payments and insolvency risks. Therefore, companies and investors need to find an appropriate balance between the tax benefits of the tax shield and the risks of higher debt when making decisions regarding capital structure and investments.
The formula for calculating the leverage effect is as follows:
In order to understand the risk effect of the tax shield, it helps to first consider the effect of the leverage effect. Debt has the effect of increasing the risk for equity providers because the interest burden does not vary, or does not vary completely, with the success of the company. If, as is usually the case, the cost of equity is higher than the cost of debt, the return and risk for equity providers increase not only in absolute terms but also in relative terms as gearing increases. The return on equity increases with a higher level of debt and vice versa.
In business valuation, it is important to determine the beta factors professionally, taking into account the certainty of the tax advantage of debt financing. A distinction must be made between the cash flow effect and the risk effect in order to determine the value of the tax shield. The beta factors module from smartZebra supports you in this.
As shown above, in addition to the disadvantage of increasing risk for equity providers, additional Debt brings the advantage of an additional tax shield. In the leverage effect, the interest does not actually increase the risk in full, but only to a reduced extent.
If this risk reduction is not only assumed ex post, but also ex ante for the expected return on equity, this is referred to as a safe tax shield, otherwise the tax shield is uncertain. You can read about the influence of this distinction in the in-depth article Uncertain vs. certain tax shield in beta factors.
The tax shield offers companies a considerable advantage through the tax deductibility of interest on Debt. It has a positive influence on the WACC and the company value by reducing the cost of capital. When determining the beta factors, it is important to distinguish between safe and unsafe tax shields to ensure an accurate risk assessment. With the right tools, such as the SmartZebra cost of capital module and beta factors module, companies and auditors can maximize the benefits of the tax shield while keeping an eye on the risks of higher debt.
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