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Tax Shield | Definition | Formula | Example | Calculation - YouTube
Channel: WallStreetMojo
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hello everyone hi welcome to the channel
of WallStreetmojo friends today we
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are going to learn a tutorial on Tax
shields
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we'll be learning a few formulas in this
regard there will be some examples and
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definitions and some calculations so
let's get into the nitty gritty of the same
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at the very inception you know that
she'll is basically savings in the
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taxable income for the corporations or
individuals by deducting the allowable
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expense like such as interest
depreciation hospital expenses etc so
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tax shield has become a very important
part of decision-making process in
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project finance and corporate finance so
in this article we are going to look
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actually in complete detail
so first let's get into what is that
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shield that is the first and the
foremost thing if we talk about tax
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shield that she'll is basically a
reduction in the or I'll say I'll just I'm
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just writing in negative that reduction
in the tax income okay it will be
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reduction in the taxable income for the
individuals or for the corporations and
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achieving through the claiming allowable
deduction such as like you know interest
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like medical expenditures charitable
donations and motivations and
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depreciations see the income reduce
reduce taxpayers taxable income for a
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given year or defer income taxes in two
future periods so it is a way to save
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you can say cash flows and increase in
the value of the form increase in the
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value of the form now the tax shield
strategy can be used basically to you
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can say increase in the value of the
business and increase in the value of
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business and since you know it reduces
the tax liability that would otherwise
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reduce the value of the entity entity's
assets now that she'll is basically part
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to save you can say cash
- outflow and appreciate the value of
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the form so Tax Shield
in away of various forms involved in
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types of expenditures that is deductible
from the taxable income in simple words
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you can say Tax shield is PV for the
present value of future tax savings
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attributes to the tax to the tax
deductible of the particular expenditure
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in the profit and loss account now let's
understand some of the importance of
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what I mean benefits of the tax shield
that is the importance of deduction see
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tax shield lower the tax bills which is
one of the major reason why tax payers
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whether individual corporation spent
considerable amount of time determining
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which deduction and grades they qualify
for each so there are some of the
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benefits of the tax shield let's
understand each one-by-one benefits of
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tax shield the first is that shield like
you know though there are some of the
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cases where it actually can be taken
like you know in case of depreciation
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and actually can be taken in case of
interest it actually can be taken in
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case of individuals and so on and so
forth so second and third now tax alone
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depreciation if we talk about the action
of depreciation is proper management of
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assets for saving the tax a depreciation
tax shield is basically a tax to
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reduction technique under which
depreciation expense is subtracted from
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the taxable income and this is the
basically non-cash item but we get
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reduction from the taxable income and
this will become a major source of the
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cash inflow which we save by not giving
the tax on the depreciation amount it's
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just like provision we create every year
in respect of the capital expenditure
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and so on and so forth let's understand
this with an example
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now let's say there is a company which
is which has investment
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project involves a capital outlay of
close enough to 90 million in a plant
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and machinery the project would have a
life of how much 5 years at the end
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of which the plant and machinery could
be could fetch close enough the value of
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$30,00,000 million so that is the salvage value you can say further the project would
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also need a working capital of $12,50,000 which would be
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built
year 1 and to be released from the
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project at the end of 5 so working
capital is this is just like capital
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budgeting based illustration the project
is expected to yield the following cash
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profits let's see what exactly is there
in our arena as you can see the cash
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profits which are given 35, 30, 25, 20 and 20 so on and so forth
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a 25% appreciation for planted
machinery available and the corporate
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tax is paid in in one year in arrears
which it relates to the first year and
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would be claimed against the profit of
the year one now over here the there are
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some other details like the management
accountant has calculated the NPV and
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the corporate target is 20%
pre-tax return the corporate tax is
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expected to be 35% during the
life of the project and those the
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company's rate of return post is 20% that is the target return into
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65% that is the post tax value
that is 13% is the post tax return
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what are we told to do to calculate the
post tax cash flow at the post tax rate
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which is very important post tax cash
flows at post-tax rate
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pre-tax cash flows at pre tax rate as
simple as that
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so calculate the NPV of the project
taking the tax shield formula into
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consideration so let's get into the
nitty gritty of the me and see what
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exactly the calculation is there right
in front of us if we go down and see we
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have couple of details regarding your
1 year of the profit the cash profits
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that we had in our table the tax on this
profits and the year of tax payment that
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will be in year 2 so this will be paid
in year 2,3,4 and so on and so
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forth it will be succeeding here now
depreciation allowance on the on the
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same now we start with year 0,1,2,3,4 on the basis of reducing
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balance method that is wdv the
depreciation has been calculated on
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which the tax rebate is taken so on this
depreciation if you multiply the tax
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rate you get what the tax rebate that is
called as the that she'll and that will
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be available in the
following years as it has been mentioned
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like 2,3,4 and 5 and so on
and so forth so if you go down you see
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the profit on the sale of the plant and
machinery is 30.000 – 21.357
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now just come
down more once you do that you have year
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investment walking capital that you are
invested then the depreciation details
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that you just found allowance that is
basically the tax saving on the DEP and
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that is basically your savings the cash
profits the tax on the profits and that
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is why it is a negative the net cash
flows is going to be your total plus all
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the savings that you make and then you
discount that with the relevant of
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discounting factor that is 13% over here and then finally you
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get the present value so once you do
that you get the final net present value
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and the net present value over here in
this case is 1.57 now
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let's start with tax shield on the
interest C interest shield in case of
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the company or corporation one of the
major important objective of the
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corporation of the former organization
is basically nothing but to reduce its
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tax liability very important for which
he has to compute the tax shield or we
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call as tax advantage and computing the
interest tax shield
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right so now let's understand the
valuation of the interest tax shield see
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first what you need to do in this
particular case is you need to
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capitalize or you can see recapitalize
you can say recap the value of the form
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and the second is limits on the tax
benefit of the debt now interest expense
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is basically you can say is opposed to
dividend and capital gain tax deductible
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therefore you know tax shield is
important factor there are tax benefits
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derived from
creative and as we know that the value
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of the interest action is basically the
present value for all the future
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interest tax shields also the value of
the levered form of our organization
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exceeds the value or else you know equal
unlevered form or organised by the value
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of the form interest tax shield so these
options is one of the live example for
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utilization of the tax shield now let's
understand interest tax shield calculation
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with an example in this example if you
see ABC Limited is considering a
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proposal to acquire a machine costing
costing of $ 1,10,000 which is payable at
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$ 10,000 down payment and balance in
10 equal monthly installments so it is
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basically on lease you can say of
Finance lease at the end of the each
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year inclusive of interest chargeable
at 15% another option before it
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is to acquire assets on lease rental is
25,000 per annum payable at the end of
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each year for 10 year so this is
basically your operating lease the
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above also your finance is the information
related to the same is present value
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factor interest rate is 15% for
10 years and we have been given the
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present value factor which is 5.019 the terminal scrap value which is $ 20,000
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which is realizable if the
asset is purchased and the company
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provides 10% as depreciation
income tax is 50% what you are
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required to do is you need to compute
and analyze the cash flow and advice to
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which option is better first option one
is to be so over here what you are doing
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is you are basically getting into a
finance lease in this option you pay $10,000
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as down payment balance $1,00,000 in the with at an interest rate of
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15% in clinical installments
and the amount of the annuity will be
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calculated as the $ 1,00,000 divided
by the the present value factor that has
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been found out over here which is 5.019 now this is your
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annual repayment that is $ 19925 now what we have just seen what
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we have seen is you know what over here
is annual repayment
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that is the EMI you can say the
discounting rate it is called as WACC why
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we use WACC, WACC is the complete cost of the company that includes the cost of
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equity cost of preference shares cost of
debt and so on and so forth so over here
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we use the same rate for leasing and
boring option and there will be no
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change in the final decision
the answer may very now the depreciation
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was 10% as we know so on the amount of
the total asset which is $ 1,10,000 * 10 %
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has been provided for all the
years the asset is fully depreciated
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during the life of 10 years and
therefore the book value at the end will
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be zero that is quite logical Salvage
which is given to us as $20,000
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and that would be a capitulation because
$20,000 minus zero is your capital
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gain presuming that you know taxable at
the normal rate of 50% of the
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net cash inflow on account of salvage
value would be $10,000 only that is
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$20,000 is your salvage value
into the 50% as the normal
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rate so the cash flow for the same is if
you go down and see year the
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installments the interest rate and the
repayment that you do is install minus
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interest that is repayment and the
balance details so that is basically
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your complete table regarding the
repayment when you come down you see
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that you know there is a payment
interest depreciation there's a tax
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shield it actually will be on 3 + 4
that is your interest on
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depreciation and the net cash flow will
be your payment less the tax shield
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because that she'll is your gain and you
will multiply with the present value
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factor to do the present of value now
the second option was leasing that is
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finally the leasing on in case of the
asset is acquired on annual lease the
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rent to be paid is $25,000
payable over here the net present value
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is 51,336 after inputting all the
details this lease rental is
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tax-deductible as we know very well but
$25,000 * 50%
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that is $12,500 so
present value factor of 10 years at the
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rate of 15% is already that
we know 5.019
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so this $12,500
into for the present value factor for
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10 years
which is 5.019 that
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gives us $ 62738 so by comparing the
above two option what we get is the
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present value of incase of buying the
tax she'll is lower as it is 51,336
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compared to the one that is the
operating lease sort of that is $ 62738
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so based on this example we can make
final conclusion that what we saw what
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we know what we need is to is to be
understood is tax shield very important
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aspect of the business valuation and it
very from country to country and the
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benefit depends upon the taxpayers
overall tax rate and cash flow for the
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given tax years so government often
create tax shield as away to encourage
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certain behavior or investment in
certain industry or programs thank
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everyone
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