 A carpet firm is required to pay tax on its earnings. But if the firm is using debt in its operations, then before paying any tax on the earnings, the firm is required to pay interest to the debt holders. So interest payments reduces earnings available for the taxes. This means that interest payments work as an incentive for the firm to use debt in its business. Now let's see that what impact interest payment can have on the taxation of the firm. Now we assume that the firm has earnings of 2.8 billion and the annual interest expense of 400 million. Now we assume two situations where we have a leverage policy of the firm and where we have the firm without leverage. For both of the situations the earnings before interest and taxes are 2.8 million and for leverage firm at first we need to pay the interest expense. So after deducting interest payment from the earnings before interest and tax, the earnings available for tax come to 2.4 million whereas for the unleavoured firm there is no interest payment so its earnings before interest and taxes are converted into earning before tax at the similar amount. Now assuming the tax rate of 35% the tax amount for the levered firms come to 840 whereas for the unleavoured firm it comes to 980. This means that the net income available for the levered firm is 1560 whereas for the unleavoured firm it is 1820. If we further analyse this situation we come to the two points that the leverage lowers net income for the levered firm because it is the debt that reduces net income for the equity holders. But if we see this situation from an other perspective we see that the interest pay to debt holders under leverage is 400 whereas for unleavoured firm it is 0 and for the equity holders the remaining amount after taxes is 1560 under leveraged policy whereas under unleavaged policy the amount available for equity holder is 1820. So the total amount available for the capital providers under leveraged policy is 1960 whereas under unleavoured policy it is 1820. Now we see that the higher amount is available to all of the investors or the capital providers under the leveraged policy and the amount is higher by 140 million dollars now the question arises that where from this 140 million an additional amount has been arisen although it seems little odd that a firm can be better off with leverage despite of the fact that the leverage reduces the net income of the firm but a firm's value is the sum that can be collected from its capital providers and not only the equity holders so we can say that unleavoured firm pays more in total to its capital providers or the investors including the interest payment to the debt holders this means that as there are more than one class of capital providers meaning by we have equity holders and the debt holders so initially the firm can collect higher amount from these two capital providers now as I have raised the question earlier that where the additional amount of 140 million dollars have been provided to the total capital providers the answer is that this gain is the interest tax shield that has been provided to the equity holders where this tax shield come from in fact the interest payment of 400 million dollars is the amount that has been saved from the taxes so the tax of 35% on this amount has generated a tax saving of 140 million dollars and that is the additional amount which is now available for the investors of the firm if the firm does not have to pay tax on the interest payment of 400 million dollars then the 400 million dollars as I have earlier said is kept saved from taxing at the rate of 35% and this tax saving comes in the form of additional amount of 140 million dollars and that is the savings a firm has for its capital providers in fact this saving of 140 million dollars available to the investors of the firm is the outcome of interest tax deductibility attribute and that tax saving on the interest admissibility as a business expense is termed as the interest tax shield now how to compute this interest tax shield for that purpose we need to multiply the tax rate on the interest expense as we have earlier seen the tax expense is 400 million dollars multiplying this amount with the tax rate of 35% the interest tax shield comes to 140 million dollars but here is a point to note that this tax saving is available only to the levered firm an unlivered firm cannot enjoy this tax saving because the unlivered firm has nothing to pay as interest expense in fact the unlivered firm is not using any debt so unlivered firm cannot enjoy interest tax shield on the screen we have a little illustration to show the demonstration of computing interest tax shield we have a firm DFB's income statement from 2012 to 2015 it we have total sales cost of sales selling and general expenses depreciation and a result we have an operating income now adding other income to this operating income we arrive at the abit or earning before interest and taxes now from this abit we deduct interest expenses and we have income before tax adding or applying tax at the rate of 30% at this amount we have net income as a result now from this illustration if we extract the interest tax shield then we need to have two items the annual interest expense and a tax rate which is 35% now multiplying the tax rate of 35% to the annual interest expense the resulting figure we will have will be called as the interest tax shield and we will see in the last line of the table where the interest tax shield for 2012 is 17.5 and for 2015 it is 35 if we add up the these four years interest tax shields we can say that these interest tax shields are enabling the firm to pay an additional amount in a total of 115.5 million to its investors over the period of four years