What is the tax shield in an LBO?

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Multiple Choice

What is the tax shield in an LBO?

Explanation:
In an LBO, the tax shield comes from the debt financing. Interest payments are deductible when calculating corporate taxes, so the company reports a lower taxable income. This reduces taxes owed and increases after-tax cash flow in each period. The larger the interest expense (i.e., the more debt relative to equity) and the higher the tax rate, the bigger the tax savings. Principal repayments don’t shrink taxes, and equity financing doesn’t generate this deduction, so the key point is that debt interest is tax-deductible, improving cash flow.

In an LBO, the tax shield comes from the debt financing. Interest payments are deductible when calculating corporate taxes, so the company reports a lower taxable income. This reduces taxes owed and increases after-tax cash flow in each period. The larger the interest expense (i.e., the more debt relative to equity) and the higher the tax rate, the bigger the tax savings. Principal repayments don’t shrink taxes, and equity financing doesn’t generate this deduction, so the key point is that debt interest is tax-deductible, improving cash flow.

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