Tax Shield
The reduction in taxable income — and therefore taxes paid — resulting from allowable deductions such as interest expense or depreciation.
What is Tax Shield?
A tax shield is any deductible expense that reduces a company's taxable income and, consequently, its tax liability. The value of a tax shield equals the deduction amount multiplied by the applicable tax rate. Common sources of tax shields include interest expense on debt (which is tax-deductible, unlike dividends), depreciation on capital assets, amortization of intangibles, and net operating loss (NOL) carryforwards. The interest tax shield is central to capital structure theory: because debt interest is deductible, using debt financing provides a tax advantage over equity financing, increasing firm value. This is captured in the Modigliani-Miller theorem with taxes. In discounted cash flow (DCF) valuation, tax shields from debt are sometimes valued explicitly (the Adjusted Present Value method) rather than embedded in the discount rate (WACC method).
Example
A company has $10 million in debt at 6% interest, generating $600,000 of annual interest expense. With a 21% corporate tax rate, the interest tax shield = $600,000 × 21% = $126,000 per year. This means the company's after-tax cost of debt is 6% × (1 − 0.21) = 4.74%, not 6% — making debt financing materially cheaper than its stated rate.
Source: Brealey, Myers & Allen — Principles of Corporate Finance, 13th ed.