Financial Management Domain Practice Test

What is the tax shield effect of debt?

Interest payments are tax-deductible, reducing taxable income and taxes paid Debt increases taxes paid Interest payments are not deductible Debt provides tax credits for investment

Correct Answer:

Interest payments are tax-deductible, reducing taxable income and taxes paid

Explanation:

Debt creates a tax shield because the interest expense is deductible from taxable income. Each dollar of interest reduces the amount of income subject to tax, so the firm saves taxes equal to the tax rate times the interest expense. For example, with a 30% tax rate, $1,000 of interest lowers taxes by $300, leaving the firm with a lower after-tax cost of that debt. This after-tax advantage is the essence of the tax shield: it reduces taxes paid and can increase the value of the firm when debt is used strategically. Anything claiming taxes rise with debt or that interest isn’t deductible is missing the key point. Tax credits are a different mechanism than the debt tax shield, which comes from the deduction of interest.

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