Interest payments made by a company are tax deductible. Consequently, a company can lower its tax burden by increasing its debt. This is known as the debt tax shield. While academics agree that this can increase the value of a firm, there is disagreement over its exact value.
Calculating the Value of Debt
Assuming no adverse effects from debt, no personal tax consequences and a single corporate tax rate, it's easy to calculate the value of a debt tax shield. In this hypothetical situation, you can use the formula L = U + tD, where L is the market value of the levered firm, U is the market value of the unlevered firm, t is the tax value of a dollar of debt and D is the market value of the debt. For instance, if the market value of the unlevered firm is $100,000, each dollar of debt has a tax value of $0.15 and the market value of the debt is $20,000, the market value of the levered firm would be $103,000. Unfortunately, the real world is much more complicated and there is no consensus on how to best value a debt tax shield. Researchers typically value it at between 5 and 10 percent of corporate debt. For a company with $50,000 in debt, this would place the value of the debt tax shield at between $2,500 and $5,000.