Return to Basics: Are You Properly Calculating Tax Shields?

Abstract:     
Everybody uses tax shields when calculating the Weighted Average Cost of Capital (WACC). The textbook formula includes the tax shield with the (1-T) factor affecting the contribution of debt to the WACC. Tax shields are a strange mix of accounting and accrual related to WACC that relies on market values.

In this short work we show some limitations and care that have to be taken into account when using tax shields. We illustrate these ideas with simple examples.

Keywords: Weighted Average Cost of Capital, WACC, firm valuation, capital budgeting, tax shields, tax savings

JEL Classifications: G12, D61, G31, H43

Working Paper Series