The Value of Tax Shield strategies by corporations will be the subject of this week’s MBA Mondays with Darwin. Have you ever found it odd that in the same day, you’ll hear the pundits on CNBC saying that IBM or Exxon are sitting on hoards of cash, but then you see that they’re still issuing bonds to raise capital? Why would a cash-rich company still be borrowing money? While some of the incentive is due to where their revenues are derived and their aversion to repatriating profits earned overseas back to the US at a higher rate, the other driver is the tax shield benefits. In a nutshell, the tax system that allows corporations and individuals to deduct debt expense from their taxable income actually incentivizes them to take on debt to boost their bottom line.
Value of Tax Shield Example
Let’s take a typical corporation and compare two different scenarios – one in which they have no debt and another scenario in which they borrow $100,000. Here are the assumptions:
- Corporate Tax Rate = 35%
- Interest Rate on Debt = 8%
- Income Earned for Comparison = $100,000
- Amount Borrowed for Company B = $100,000
(click to enlarge)
- Output – 5.2% Effective Interest Rate
As you can see from the tax shield value example, the company that borrowed using debt issued at 8% is really borrowing it at an effective rate of only 5.2% because of the tax shield.
Benefit of Tax Shield
This isn’t to say that by the sheer notion of borrowing funds, the firm is somehow generating excess profits out of thin air. However, most companies in growth industries are able to earn double digits on their investments. For instance, if Intel is going to invest in a new chip plant, their assumed long-term return on invested capital might be something like say, 15%. Well, rather than deploying that capital out of their existing cash reserves, they are actually getting a better ROI by borrowing and making that return. At that 5% effective rate to borrow, they’re practically tripling their return as opposed to earning 15% on existing cash. What makes this model so compelling is the high corporate tax rate. Think about it – 35% is about 1/3 of all profits – gone. So, anything a corporation can do to offset taxable income is a benefit.
This is a simplified explanation and example, but hopefully, seeing the concept and formula helps you understand why companies borrow when they seem to have a ton of cash on hand. Why would a company “borrow to pay a dividend”? That seems to make no sense. It’s because they want to do both – reward shareholders (and employees who hold stock) with a dividend, while enjoying high ROIs on their new investments.
Individuals use tax shields all the time too. A mortgage, right? Since I’m able to deduct mortgage interest, I can borrow at say, 4.625% and pay an effective rate of around 4% while investing at a higher rate elsewhere. Granted, I own a home because I actually want to be a homeowner and the mortgage interest deduction is a fringe benefit, but many people use home equity loans and other means to generate tax shields either for their own finances or for their small business.