SFM

Cases & Concepts

Class

Here’s a concrete, numeric example showing the tax shield.

Setup

• EBIT: $1,000,000
• Debt: $5,000,000 at 6% interest → Interest = $300,000
• Tax rate: 25%

Case A — No debt (no interest, no shield)

• EBIT: $1,000,000
• Interest: $0
• EBT: $1,000,000
• Taxes: $1,000,000 × 25% = $250,000
• Net income: $750,000
• Free cash impact from tax shield: $0

Case B — With debt (interest tax shield)

• EBIT: $1,000,000
• Interest: $300,000
• EBT: $700,000
• Taxes: $700,000 × 25% = $175,000
• Net income: $525,000
• Tax shield (cash saved): Interest × Tax rate = $300,000 × 25% = $75,000

Interpretation

• The government “covers” $75,000 of your interest via lower taxes.
• Economic cost of interest after tax = $300,000 − $75,000 = $225,000
• Same formula: After‑tax cost of debt = 6% × (1 − 0.25) = 4.5%

Quick variant with depreciation shield

• If annual depreciation is $200,000, the depreciation tax shield adds $200,000 × 25% = $50,000 of cash tax savings, even though depreciation itself is non‑cash.