The Interest Tax Shield and Write-offs Explained – Part 2: The Interest Tax Shield

In my previous post we covered the importance of purchasing decisions. Since most large purchases are done on credit, let’s now discuss the interest tax shield created from using that credit.

When you purchase something on credit, you are charged interest until the loan is paid off.  Figure 1 is an example of an amortization table for a 60 month(5 year) $100,000 loan at 4% interest.  As you can see from the table, the amount of every payment is made up of interest and principle. Notice how the interest portion decreases while the principle portion increases over the course of the loan. This is typical.

Figure1

There are two things you are able to write-off with big purchases like this and that is the interest incurred and the depreciation. I’m not an accountant, but I do have an understanding of depreciation and how it affects tax liability. Figure 2 below shows the annual straight-line depreciation in column 2 of a $100,000 purchase with a salvage value of $10,000 over 5 years. The straight-line depreciation method subtracts the salvage value from the purchase price and then divides that number by the number of years. (i.e. $100,000 – $10,000 = $90,000/5 = $18,000)

Figure2

Columns 3-5 of Figure 2 shows the total principle paid each year (3), total interest paid each year (4), and the total of all of the payments to the bank each year (5). The reduction in tax liability is derived from adding the amount of depreciation and interest for each year. This is where it gets tricky. If you compare this total to the amount of the yearly cash outflow incurred from financing you will find that you still have a tax liability that you will need to pay on. In other words, you paid out more than your possible tax reduction.

Normal expenses are written off 100%. However, in this scenario, you received a 98% write-off in Year 1 and an 83% write-off in Year 5. Assuming a tax rate of 35% your total tax liability in this scenario over the 5 years is $10,000 x 35% = $3,500. Add this number to the total interest paid and you get around $14,000 paid over price to make that purchase. The notion of a tax shield doesn’t seem like much of a shield now does it?

On the flip side, let’s say you paid cash instead of taking out a loan. Since you can’t write off large asset purchases in the year they were made, you would end up paying 35% in taxes of $82,000 when you subtract out Year 1 depreciation totaling $28,700. The $82,000 is perceived as profit even though it’s not in the bank. This is a significant up front cost, but it gets paid back to you by being able to depreciate that asset over the next 4 years. This means that your tax liability is reduced by $18,000 each year resulting in a future saving of $25,200 at the end of year 5. In this scenario, you only paid an additional $3,500 to make the purchase rather than the $14,000 in the previous scenario.

So the answer to the question of cash vs. credit can be answered fairly simply if this was all you needed to worry about. Other factors that will influence your decision is the need for operating cash flow, immediate necessity, opportunity costs that could come up later, and the overall financial health of your business. Debt is a tool to be leveraged and a cost benefit analysis will tell you if it’s worth the risk.

Click here to be taken to the next post in this series about write-offs!

 

 

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