Tax Savings in an LBO

• A. The higher leverage, higher tax rate, and higher interest rate maximize tax savings
• B. Tax savings are maximized when leverage is zero
• C. Tax savings decrease as interest rate increases
• D. Tax savings are independent of debt and interest

Answer: (A)

In an LBO, the key idea is that interest on debt is tax-deductible, so debt creates a tax shield. The size of that shield grows with how much interest you pay, which depends on both how much you borrow (leverage) and the interest rate on that debt, and it’s also larger when the corporate tax rate is higher. If you denote debt by D, the interest rate by r, and the tax rate by t, the annual tax savings from the interest shield is roughly t × (D × r). So increasing leverage (more debt), increasing the interest rate, or operating in a higher-tax environment all boost tax savings. Of course, higher leverage also increases financial risk and can affect feasibility, but the tax benefit itself rises with those three factors. The other statements miss this relationship: with no debt there’s no interest deduction; tax shields depend on debt and interest; and the shield does not shrink simply because interest rises.