17. Corporate Finance Essentials. The debt tax shield

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Corporate Finance Essentials. The debt tax shield

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    Popular Comments:

Master Shake . 2019-11-07
Fantastic, this video made me hate my finance teacher....
121 2 . Reply
shriya . 2019-06-29
121 2 . Reply
João Pedro Zardi . 2019-06-15
Awesome explanation!
121 2 . Reply
Severin Kröger . 2018-12-13
Actually the second part of the explanation why this is useful is missing. The company which has no debt still needs financing for its business activities. Since they don't have debt, they need to have 100% equity financing (by issuing stocks for example). So Company A with a Net Income of 65M$ now needs to pay its stockholders from the Net Income and stockholders will always request higher compensation than banks for their debt. So if you assume that the cost of equity is for example 12% (opposing to only 8% cost of debt) company A now has to pay a higher amount to their stockholder. And these dividend payments are not tax deductible. Eventually you have a higher capital outflow out of the company than Company B which has lower amount of equity and thus lower costs of equity.
Calculation (image both firms have an overall capital of 200M$)
Company A: 200M$ (equity)*12%=24M$ -> 65M$ (Net Income) - 24M$ (Dividend payments) = 41M$ left over for the company
Company B: 100M$ (equity since they borrowed 100M$ as debt and we payed for that already)*12%=12M$ -> 59,8M$ (Net Income) - 12M$ (Dividend payments) = 47,8M$ leftover for the company
Now company B has 6,8M$ more for the next year to invest.
121 2 . Reply
Zach Snow . 2018-11-14
Thank you. This was a fantastic explanation
121 2 . Reply
Pretty much the coolest in da hood . 2018-11-12
Yet, my net earnings are higher if I don't have interests to pay. What is the point of having a tax shield, if I still would have higher profit without any shield?
121 2 . Reply