Question

Calculate the annual value of an interest tax shield under the assumption that a firm maintains debt at a permanent $1,000,000 level and rate of 12 percent. The corporate tax rate is 35 percent. If there is no chance of financial distress, how does the value of the firm change as a result of this debt?

Answer 1

Tax shield = Debt value x Interest rate x Tax

Tax shield = 1000000 x 12% x 35%

Tax shield = $42,000

The value of firm changes as debt get added into the existing capital structure of the firm. The firm can add up new projects and the cost of capital also gets reduced because tax shield and the average debt cost which is lower than the cost of equity. The firms become open to the projects which have moderate return as cost of the capital of the firm is reduced by way of adding debt. Debt increases the asset based, lowers the cost of capital, improves the leverage and tax shield is added advantage which finally contributes to value of the firm.