The Interest Tax Shield: Valuations, LBO Models, and More

Interest Tax Shield Definition: In corporate finance, the “interest tax shield” refers to the tax reduction a company gets by issuing Debt and paying Interest on that Debt; it is roughly equal to the Interest Expense * Tax Rate, but it may be reduced or limited in certain regions based on the company’s EBIT, EBITDA, or other attributes.

For example, if a company has $1,000 of Debt at a 10% Interest Rate, it pays $100 in Interest Expense per year on the Debt.

Since the interest is tax-deductible, its tax burden is reduced by $100 * Tax Rate.

In most developed countries, the corporate tax rate is between 20% and 30%, so at a 25% rate, this is a $25 reduction.

As a result, the company spends a “net amount” of $75 rather than $100 due to this tax deduction.

Its after-tax profits (Net Income) are still down, but they’re down by $75 rather than $100.

The interest tax shield should be an organic part of any LBO model and does not require a separate schedule in simple cases.

You can see it on the Income Statement in the Pre-Tax Income and Net Income area:

In more complex cases, the Interest Expense may not be fully deductible (see the full walkthrough below).

So, if we assume that it’s only deductible up to a certain percentage of Operating Income (EBIT), the IRR (annualized returns) in the deal decreases.

However, since the effect size is small, the IRR remains in a narrow range regardless of the limit:

In a DCF-based valuation, the interest tax shield is reflected in the WACC calculation because you multiply the company’s Pre-Tax Cost of Debt by (1 – Tax Rate) for use in the standard formula:

The Interest paid on Debt is tax-deductible, which makes Debt even cheaper than Equity.

Note, however, that the interest tax shield is only part of the explanation; Debt is cheaper than Equity mainly because its risks and potential returns are lower.

Files & Resources:

• Simple LBO Model – Interest Tax Shield Schedule (XL)
• Levered and Unlevered FCF Examples with Tax Calculations (XL)
• Interest Tax Shield Presentation (PDF)

The Interest Tax Shield in Valuation and DCF Analysis

The main point here was stated above: Always multiply the Pre-Tax Cost of Debt by (1 – Tax Rate) to get the After-Tax Cost of Debt for use in the WACC calculation.

Normally, you estimate a company’s Cost of Debt by calculating the Yield to Maturity (YTM) on its existing bonds, but you could also take the Risk-Free Rate and add a Credit Default Spread corresponding to the company’s credit rating.

You could even divide the company’s Interest Expense by its average Debt balance, but this is not ideal since it doesn’t reflect current market rates.

If you use Unlevered FCF in a traditional DCF, you should NOT factor in any interest tax shield because UFCF is capital structure-neutral. The taxes must be based on the company’s EBIT and ignore the Interest Expense.

In other words, the Taxes the company pays in the UFCF calculations stay the same regardless of whether it pays 5%, 10%, or 15% interest on its Debt, and regardless of any deduction limits:

UFCF is capital structure-neutral, so it is not affected by the company’s Debt vs. Equity mix or the specific terms or interest rates on its capital.

However, the Discount Rate used in a DCF – whether the Cost of Equity or WACC – is never capital structure-neutral.

It changes as the company’s Debt vs. Equity mix, interest rates, and other terms change.

Therefore, the Interest Tax Shield affect the output even in an Unlevered DCF because of its impact on WACC.

It’s just that it makes a much bigger impact in a Levered DCF since both the Free Cash Flow and the Discount Rate change there.

The Interest Tax Shield in LBO Models and Deduction Limits

In a simple LBO model, you do not need to do anything “special” or “different” to account for the Interest Tax Shield.

If you have set up your model properly, with standard Pre-Tax Income and Net Income calculations, it happens organically:

However, some countries limit the amount of Interest Expense a company can deduct.

For example, in the Tax Cuts and Jobs Act (TCJA) passed in the U.S. in 2017, companies could initially deduct Interest Expense only up to 30% * EBITDA.

After 2022, this rule shifted to 30% * EBIT, which is much less favorable since EBIT is lower than EBITDA.

It’s a lower deduction limit, which means reduced tax savings from the Interest Expense.

Some case studies ask candidates to account for these limits, but they’re uncommon in simpler tests, such as 60-minute LBO modeling tests.

As an example, here’s what happens in this simple LBO model if we allow for Interest Expense deductions up to different percentages of EBIT or EBITDA:

Factors That Matter More Than the Interest Tax Shield in LBO Models

Virtually every other assumption matters more than the interest tax shield: The purchase price, the exit multiple, the % debt used, the revenue growth rates, and the operating margins.

The interest rate on Debt, such as 5% or 10%, also makes a bigger impact, though it is still less important than the abovementioned assumptions.

The Interest Tax Shield affects only the Cash Generated and Debt Repaid during the holding period of an LBO, not the Exit Multiple, Exit EBITDA, or EBITDA Growth.

However, in most LBO models, the Cash Generated and Debt Repaid make a small impact next to these other factors:

Cheaper effective financing improves deal outcomes but is far less significant than the core business growing at different rates.

The Interest Tax Shield makes a larger impact when interest rates are much higher, such as 14% rather than 6%:

However, if a company pays a 14% interest rate on its Debt, it is likely a very risky company with inconsistent cash flows at a higher risk of financial distress.

A company in this category is unlikely to generate much Cash or repay much Debt in the holding period of an LBO model.

Therefore, this example is a bit artificial because this scenario would probably not happen in real life.