Which concept explains how debt's interest expense reduces a firm's tax bill?

Which concept explains how debt's interest expense reduces a firm's tax bill?

• A. Tax shield
• B. Cost of capital
• C. Liquidity preference
• D. Market efficiency

Answer: (A)

Debt's interest expense reduces a firm's tax bill because interest is tax-deductible. Taxes are paid on taxable income, which is typically earnings before tax minus interest. By deducting interest, taxable income drops, so the taxes owed are smaller. The tax saving from this deduction is the tax rate multiplied by the interest expense, and the value of these saved taxes is what we call the debt tax shield. This shield boosts the firm’s after-tax cash flows and, all else equal, can raise the firm’s value. For example, if earnings before tax are 100, the interest subtracts 20, and the tax rate is 30%, taxes fall from 30 to 24, saving 6 in taxes. This tax shield is the mechanism behind why debt can appear attractive. Other concepts like cost of capital, liquidity preference, or market efficiency describe different ideas and do not explain the tax-reduction effect of debt.

Debt's interest expense reduces a firm's tax bill because interest is tax-deductible. Taxes are paid on taxable income, which is typically earnings before tax minus interest. By deducting interest, taxable income drops, so the taxes owed are smaller. The tax saving from this deduction is the tax rate multiplied by the interest expense, and the value of these saved taxes is what we call the debt tax shield. This shield boosts the firm’s after-tax cash flows and, all else equal, can raise the firm’s value.

For example, if earnings before tax are 100, the interest subtracts 20, and the tax rate is 30%, taxes fall from 30 to 24, saving 6 in taxes. This tax shield is the mechanism behind why debt can appear attractive. Other concepts like cost of capital, liquidity preference, or market efficiency describe different ideas and do not explain the tax-reduction effect of debt.