Tax shield and other advantages of debt financing

Financing your firm by means of debt financing can provide you with a lot of advantages. For example, you won’t have to give up business ownership. Your only obligation is to make payments on time for the life of the loan. In contrast, if you finance your firm using equity, you might have to worry about interference from other parties regarding the future of your firm. Another very useful advantage is the fact that debt can be fuel for growth, especially low-interest long-term loans. These loans can provide your firm with working capital needed to keep the business running smoothly and profitably. Furthermore, debt financing can be very helpful for small business or start-ups, since small business owners rely heavily on expensive debt like cash advances or credit to get their business started. The problem here is that these expensive debts require a lot of cash flow and this can hinder day-to-day operations. Debt financing can provide a solution for these small businesses, since the usage of debt financing can ensure the payoff of these high-cost debts. Because of this, monthly payments can be drastically reduced, resulting in lower cost of capital and boosts of business cash flow. It is therefore often more interesting for start-ups to use debt financing instead of equity financing.

It is clear that debt financing can have a lot of advantages, but one of the most important ones is definitely the tax shield that debt financing creates. A tax shield can be described as an allowable deduction from taxable income that leads to a reduction of taxes owned. The interest on debt is considered an expense, just as any other expense, and taxes are paid after the deduction of this expense. This way, debt creates a certain tax shield. Tax shields provide a way to save cash flows and increase the value of a firm. As a consequence, these tax shields have a big influence on investment strategies, since it is cheaper for firms and investors to finance with debt instead of financing with equity.

As can be observed, a levered firm can pay its investors more cash flows in comparison with an unlevered firm. The difference is the interest tax shield. Note that the interest tax shield can only be positive if the EBIT is greater than the interest payment.

Furthermore, from a more general perspective, tax shields can vary from country to country and are based on what deductions are eligible and ineligible. The most common expenses that can be deductible are interest, mortgage, amortization and depreciation. Governments often use tax shields in order to encourage certain behaviour or investment in different industries. For example, the deduction of mortgage interest is considered a tax shield meant to increase homeownership in the US. This can definitely be a useful benefit for people who are interested in buying a new home while lessening their tax liability. This way, not only firms but also individuals can benefit from a tax shield.