Question

The interest tax shield plays a key role in the WACC valuation framework. Discuss in detail.

Answer 1

WACC formula =(weight of debt*cost of debt*(1-tax rate)+(weight of equity*cost of equity)

Companies raises debt which is part of capital structure. The interest expenses paid on this debt is tax deductible which is called tax shields.

For example, a company with a 10% cost of debt and a 30% tax rate has a cost of debt of 10% x (1-0.30) = 7.0% after the tax deduction. That’s because the interest payments companies make are tax deductible, thus lowering the company’s tax bill. Ignoring the tax shield ignores a potentially significant tax benefit of borrowing and would lead to undervaluing the business.