How to calculate the after-tax cost of debt
/What is the After Tax-Cost of Debt?
The after-tax cost of debt is a firm’s interest expense, minus the related reduction in income taxes caused by the tax deductibility of the interest expense. It is useful to understand your after-tax cost of debt, since (depending on the government) the interest expense on your debt can be tax-deductible. Depending on your tax rate, the deductibility of interest expense can effectively drive down your net interest expense by a substantial amount. When this is the case, it can make sense to take on a larger amount of debt to fund business activities, since it is so cheap to do so. The after-tax cost of debt is also useful information for investors, which can use it to estimate a firm’s cost of capital. When the cost of capital is low, a business can more cheaply acquire financing, which enhances its ability to invest in more profit-making endeavors.
The after-tax cost of debt is included in the calculation of the cost of capital of a business. The other element of the cost of capital is the cost of equity.
The Formula for the After-Tax Cost of Debt
The after-tax cost of debt is the initial cost of debt, adjusted for the effects of the incremental income tax rate. To calculate it, subtract the company’s incremental tax rate from 100% and then multiply the result by the interest rate on the debt. The formula is:
Before-tax cost of debt x (100% - incremental tax rate)
= After-tax cost of debt
The after-tax cost of debt can vary, depending on the incremental tax rate of a business. If profits are quite low, an entity will be subject to a much lower tax rate, which means that the after-tax cost of debt will increase. Conversely, as the organization's profits increase, it will be subject to a higher tax rate, so its after-tax cost of debt will decline.
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Example of the After-Tax Cost of Debt
A business has an outstanding loan with an interest rate of 10%. The firm's incremental tax rates are 21% for federal taxes and 5% for state taxes, resulting in a total tax rate of 26%. The resulting after-tax cost of debt is 7.4%, for which the calculation is:
10% before-tax cost of debt x (100% - 26% incremental tax rate)
= 7.4% after-tax cost of debt
In the example, the net cost of debt to the organization declines, because the 10% interest paid to the lender reduces the taxable income reported by the business. To continue with the example, if the amount of debt outstanding were $1,000,000, the amount of interest expense reported by the business would be $100,000, which would reduce its income tax liability by $26,000.
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