Debt beta is the result of the ratio of credit spread and market risk premium. If it is taken into account, the company value usually increases.
Does the capital structure influence the value of the company?
In an ideal world, the capital structure does not play a role in company valuation, at least if you Modigliani—Miller theorem follows, which was developed in 1958 by economists Franco Modigliani and Merton Miller. Accordingly, the value of a company can be determined solely by the expected cash flows and the risk of this cash flow. In practice, however, the assumptions made for this financial concept are rarely given. Bankruptcy costs, taxes and transaction costs are omnipresent, which means that the capital structure and the associated interest rates usually have an impact on the value of the company.
Definition Tax Shield
The Tax Shield is understood to mean the tax advantage of debt financing due to the deductibility of interest from the tax base: By deducting interest payments on loans, a company can reduce its tax burden and thus reduce its capital costs. This leads to a tax-related increase in the value of a company through the raising of borrowed capital. The Tax Shield is therefore the tax relief for borrowing costs, which can increase the value of a company.
In Germany, this generally applies in full to corporation tax and 75% to business tax, while in many countries there is a full tax deductibility of interest on borrowed capital. The cash flow effect of the tax shield is created by deducting interest payments on loans from the taxable income base.
Auditors need a good understanding of tax regulations in order to be able to fully assess their impact on company value. The focus here is on the Tax Shield, which has an effect on WACC and cash flow and significantly influences the calculation of the beta factor.
Calculate Tax Shield: Formula and Example
Calculating the Tax Shield is relatively simple and is done by multiplying the interest rate by the tax rate. The formula is:
Tax Shield = interest payments on debt capital x tax rate
For example, if a company has interest payments on debt capital of 200,000 euros and the tax rate is 30%, the Tax Shield is calculated as follows:
Tax Shield = 200,000 euros x 0.30 = 60,000 euros
This means that by using borrowed capital instead of equity, the company achieves an annual tax saving of 60,000 euros. The value of the tax shield is equal to the present value of all future tax savings.
Relevance in company valuation
In the income value process, the Tax Shield is directly included in the income calculation. When using the DCF method, this is usually included in the weighted average cost of capital (WACC) by reducing borrowing costs by the amount of the exempted tax rate.
The formula for calculating WACC is:
Accordingly, higher debt leads to a higher Tax Shield, which leads to a lower WACC and higher enterprise value. With the SmartZebra Capital Cost Module The WACC can be calculated professionally and efficiently.
Tax Shield and WACC in the context of the leverage effect
In addition to the Tax Shield and WACC, another parameter is relevant when evaluating the influence of debt capital and the associated level of indebtedness on the company value: Leverage describes the influence of debt on the return on a company's equity. In the case of the leverage effect, higher debt leads to a higher share of borrowing costs, which can lead to a higher return on equity. This is particularly true when the expected return on the company's investments is higher than the cost of borrowed capital.
The leverage effect can help increase the profitability of investments by increasing profit on equity. However, it also increases the risk, as higher debts also mean higher interest payments and insolvency risks. When making decisions regarding capital structure and investments, companies and investors must therefore find an appropriate balance between the tax benefits of the tax shield and the risks of higher indebtedness.
The formula for calculating the leverage effect is:
What is the risk effect of the Tax Shield?
In order to understand the risk effect of the tax shield, it helps to first look again at the effect of the leverage effect. Debt capital therefore increases risks for equity investors because the interest burden does not or does not vary completely with the success of the company. If — as usual — the cost of equity is higher than the cost of borrowing, the return and risk for equity providers will increase as the debt ratio rises, not only in absolute terms, but also relatively. The return on equity increases with higher indebtedness and vice versa.
Unsafe vs. secure tax shield with the beta factor
In company valuation, it is important to determine the beta factor professionally and to take into account the security of the tax advantage of external financing. A distinction must be made between the cash flow effect and the risk effect in order to determine the value of the tax shield. (The SmartZebra beta factor module helps you with this.)
As described above, in addition to the disadvantage of increasing risk for equity investors, additional borrowed capital has the advantage of an additional tax shield. As a result, the leverage effect of interest rates does not in fact increase risks in full, but only reduces them.
If this risk reduction is assumed not only ex post but also ex ante for the expected return on equity, this is referred to as a so-called secure tax shield, otherwise the tax shield is uncertain. You can read about the influence of this distinction in the in-depth article Unsafe vs. secure tax shield with the beta factor.