Tax Shield
Investment Banking glossary · Investment Banking Valuation
Definition
The cash-tax reduction created by a tax-deductible expense. Interest tax shield = Interest Expense × t — the reason after-tax cost of debt is r_d · (1-t) in WACC and why levered firms can be more valuable than identical unlevered firms. In a DCF, taxes in UFCF are computed on EBIT (not actual taxes paid) precisely to avoid double-counting the interest tax shield — once in the cash flows and again in WACC. NOLs and depreciation also create tax shields: NOL Tax Shield = NOL × t; D&A Tax Shield = D&A × t.
Tax Shield in plain English
Here's a quietly powerful idea: some expenses are 'tax-deductible,' meaning the government lets you subtract them from your income before calculating the tax you owe — so spending on them actually shrinks your tax bill. A tax shield is just the dollar value of that saved tax. The classic example is interest on debt: if a company pays interest and its tax rate is t, it saves Interest × t in taxes, which is exactly why borrowing can quietly make a company more valuable than an identical one with no debt. Other things create shields too — past losses (NOLs) and the wear-and-tear write-off called depreciation both reduce taxable income the same way. Finance pros are careful to count this saving only once, either inside the cash flows or inside the discount rate, never in both places, or the math double-pays you for the same benefit.
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Practice Tax Shield
When calculating the WACC, why is the cost of debt multiplied by (1 - t)?
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