Interest tax shield

An interest tax shield is the reduction in a company's tax bill that comes from deducting the interest it pays on its debt. In most tax systems interest is treated as a business expense, so it lowers taxable income, and the tax saved is roughly the interest expense multiplied by the company's tax rate. A company paying $100 million in interest at a 25% tax rate saves about $25 million in taxes it would otherwise have owed.

This is the main reason debt tends to be a cheaper source of funding than equity. Dividends paid to shareholders come out of profit that has already been taxed, while interest is paid before tax, which is why cost of debt is usually quoted on an after tax basis.

The shield only has value when a company earns enough taxable profit to use the deduction. A business that is losing money gets little or nothing from it, and many tax systems cap how much interest can be deducted each year. The benefit also comes with the fixed payments and default risk that every borrower takes on, so a larger tax shield is not a reason on its own to favour more debt. Weighing the tax saving against that added risk is a central question when judging whether a company's capital structure makes sense.