Tax shields typically represent deductions a business may claim on its taxes in order to reduce its tax liability. These items may include items such as charitable donations, mortgage interest, certain medical expenses, and amortization or depreciation, among other items. The present value of tax shields is the amount of money these future deductions are worth today. Factors that most often affect it are the length of an item, interest rates, and inflation. These factors — and others — may all be present at one time or individually affect tax shields at one time or another.
The length of an item is the number of years a company will be able to claim tax shields against its taxes. For example, a mortgage with allowable interest deductions typically lasts more years than medical expenses. The present value of tax shields that last more than one year is typically of great importance in the calculation of an item’s net present value. The longer an item exists, the higher the present value for the deduction in most cases. Companies may look at the tax benefits of different projects when making selections among several new options for creating higher business revenue.
Most long-term tax shields have an associated interest rate, such as a mortgage or bank loan. Other times, a project may require a mix of external funding, which results in a mix of funding that includes various interest rates, or cost of capital. Higher interest rates may result in a more profitable present value of tax shields. The end result is a higher deduction for each year that lowers a company’s tax liability. Most likely, the deduction will decrease over each year the company holds the loan, but the amount deducted may be higher than a lower interest rate.
The final major factor is inflation present in the market, which can greatly affect a company’s taxes and deductions. The result of inflation typically means that the purchasing power of dollars goes down as inflation goes up and vice versa. The present value of tax shields may be negatively affected as interest rates may spike if inflation increases precipitously. This can create a negative situation where a company loses the benefit of tax deductions. Inflation also increases the spending to get major projects started as more money is necessary to put the projects into place.