After-Tax Cost of Debt
IntermediateThe after-tax cost of debt is the interest rate a company pays on its borrowing after taking into account the tax savings from deducting interest from taxable profit.
In many countries, companies can deduct interest payments when calculating taxable profit. This means part of the interest cost is effectively paid by lower taxes. The after-tax cost of debt reflects this saving.
It is calculated by multiplying the pre-tax cost of debt by one minus the tax rate. If a company pays 6% interest and its tax rate is 25%, the after-tax cost of debt is 6% multiplied by 0.75, which is 4.5%.
To see why, imagine the company pays 60,000 of interest on a 1 million loan. Deducting that interest reduces taxable profit by 60,000, saving 15,000 of tax at a 25% rate. The true cost to the company is 45,000, or 4.5% of the loan.
The after-tax cost of debt is used in the weighted average cost of capital. The tax benefit only applies if the company is profitable enough to pay tax and if local rules allow the deduction; some countries limit how much interest can be deducted. This tax advantage is one reason companies use debt in their capital structure.
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