Tax shield

A tax shield is the tax saving made by using debt rather than equity. Because of tax shields, it is necessary to adjust the cost of debt when comparing it to the cost of equity.

A typical tax shield adjustment is that usually done in WACC calculations, where the usual approach is to multiply the interest rate by:

1/(1 - t)

Where t is the percentage tax rate.

This does not mean that debt capital is always a lot more tax efficient than equity — although it usually is. Interest income is often taxed at a higher rate than equity dividends in the hands of investors, which can offset its tax advantage at the company level.

An alternative to adjusting the cost of debt using tax shields is to use an APV: using the cost of equity as the discount rate and then make separate adjustments for tax (and any other) effects of financing on cash flows.