(^272) Financial Management
Interest tax shield (INTS) is an inflow to the firm and therefore, it is valuable. Suppose
that firm L will employ debt of Rs 5,000 forever. If firm Lís debt of Rs 5,000 is
permanent, then the interest tax shield of Rs 350 is a perpetuity. What is the value of
this perpetuity? For this, we need a discount rate which reflects the riskiness of those
cash flows. The levered firmís after-tax earnings consist of operating income and
interest tax shield as given below:
After-tax earnings of all investors = After-tax operating income + Intemst tax shield

X
(1 - T)+ TkdD
In case of the unlevered firm, the after-tax earnings are simply:
X

(1-T)

The cash flows arising on account of interest tax shield are less risky than the operating

income which is subject to business risk. Interest tax shield depends on the corporate

tax rate and the firmís ability to earn enough profit to cover the interest payments. The

corporate tax rates do not change very frequently, Firm L can be assumed to earn at

least equal to the interest payable otherwise it would not like to borrow, Thus the cash

inflows from interest tax shield can be considered less risky, and they should be

discounted at a lower discount rate. It will be reasonable to assume that the risk of

interest tax shield is the same as that of the interest payments generating them. Thus,

the discount rate is 14 per cent, the rate of return required by debt-holders. The present

value of firm Lís perpetual interest tax shield of Rs 350 is:

PV of interest tax shield =

350

= Rs 2,500^0.^14

Note that the government, through its fiscal policy, assumes 50 per cent (the corporate

tax rate) of 0.14 firm Lís Rs 5,000 debt obligation.

Under the assumption of the permanent debt, we can determine the present value of

the interest tax shield as follows:

PV of interest tax shield =

Tax rate Interest

Cost of debt

¥

PVINTS =

T k D

k

d TD

d

¥( ¥ )=

...(12)

Thus the present value of the interest tax shields (PVINTS) is independent of the cost

of debt it is simply the corporate tax rate times the amount of permanent debt (TD).

What is the total value of firm L (that is, the levered firm)? It is the sum of the present

value of the after-tax operating income and interest tax shield. The operating income,

R (1 - T), of the levered firm is equal to the after-tax earnings of the pure-equity (that

is, unlevered) firm U. The equity- capitalisation rate (the opportunity cost of equity) of

a pure-equity firm, ku, should be used to discount the stream of operating income. Thus