Tax Shields

Lesson:

A tax shield is a method to reduce taxable income through the use of deductions. In many cases, the deduction is due to interest payments from debt.

The formula we use is: TAX SHIELD = TAX RATE X INTEREST EXPENSE

You're a tax accountant looking at a firm's use of debt as a tax shield.

The only relevant information you've discovered is as follows:

  • The tax shield is $3,570.00.
  • The interest expense is $17,000.00.
What is the tax rate?

Answer:

  • The tax rate is 0.21.

Explanation:

  1. First, let's remember the formula we need:
    TAX SHIELD = INTEREST EXPENSE × TAX RATE
  2. Next, let's plug in the numbers that we know. The order that we fill in the numbers doesn't matter.
  3. Let's plug in the interest expense.
    TAX SHIELD = $17,000.00 × TAX RATE
  4. Let's plug in the tax shield.
    $3,570.00 = $17,000.00 × TAX RATE
  5. Finally, we just have to solve for tax rate.
    0.21 = TAX RATE
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