Question

"The interest paid by a firm is tax-deductible and is referred to as interest tax shield. This is the additional amount that a firm would have paid in taxes if it did not have any debt in its capital structure."

True or False?

Answer 1

True

Step-by-step explanation:

For raising long term finance, a firm may resort to different means such as issue of common stock or issue of bonds or debentures.

Shareholders are to be paid dividends while debenture holders are to be paid periodic interest. The difference being, unlike dividend, interest paid on bonds is a tax deductible expense.

For example, if a firm issues a $1000 8% bonds and the firm's profits are subject to taxation at the rate 30%. Further suppose, the firm earned $5000 profits. Then, the interest paid on $1000 bond i.e $ 80 would be deducted from $5000 and the income that would eventually get taxed would be $4920.

Hence, in the above case, had the firm not issued bonds, the whole of $5000 would've been taxable at 30% rate.

The tax saved by such bonds being $ 80 × 30% i.e $24

This $24 represents interest tax shield. This means, had there been no debt in the firm's capital structure, it would've ended up paying this additional amount of $24 as taxes.