How to Calculate After-Tax Cost of Debt
The after-tax cost of debt can be calculated by adjusting the interest rate paid on the debt for the tax savings that come from being able to deduct the interest expense. Here is a simple formula to calculate the after-tax cost of debt:
After-tax cost of debt = Interest rate on debt * (1 – Tax rate)
Here’s how you would calculate it:
- Identify the interest rate on the debt: This is usually provided in the loan agreement and is often given as an annual rate.
- Identify the tax rate: This is the corporate tax rate that applies to the company’s profits.
- Calculate the after-tax cost of debt: Multiply the interest rate by the quantity one minus the tax rate.
Remember, the idea behind this calculation is that interest expense is tax-deductible. Therefore, the net cost of the debt to the company is reduced by the amount of the tax shield. This gives a more accurate picture of the true cost of debt to the company.
Also note, the after-tax cost of debt is a company’s net cost of debt, considered from a tax-adjusted basis. For individuals, interest on personal debt (like credit cards and auto loans) is generally not tax-deductible, so there wouldn’t typically be an “after-tax cost of debt” for personal debt.
Example of How to Calculate After-Tax Cost of Debt
Suppose a company has taken on debt with an annual interest rate of 6%. The corporate tax rate for this company is 25%.
Here’s how we would calculate the after-tax cost of debt:
- Identify the interest rate on the debt: The annual interest rate is 6%, or 0.06 in decimal form.
- Identify the tax rate: The corporate tax rate is 25%, or 0.25 in decimal form.
- Calculate the after-tax cost of debt: Multiply the interest rate by the quantity one minus the tax rate.After-tax cost of debt = 0.06 * (1 – 0.25) = 0.06 * 0.75 = 0.045 or 4.5%.
So, in this example, the after-tax cost of debt is 4.5%. This means that after considering the tax shield from the interest expense, the effective cost of debt for the company is 4.5% per year.
