Definition of After-Tax Cost of Debt
The after-tax cost of debt is the interest paid on the debt minus the income tax savings as the result of deducting the interest expense on the company's income tax return.
Example of After-Tax Cost of Debt
Let's assume that a regular U.S. corporation has:
- A loan with an annual interest rate of 10%
- An incremental tax rate of 30% (combination of federal and state)
If the corporation has a loan of $100,000 with an annual interest rate of 10%, the interest paid to the lender will be $10,000 per year. This interest expense will reduce the corporation's taxable income by $10,000 thereby saving the corporation $3,000 in income taxes (30% tax rate on $10,000 reduction in taxable income).
The after-tax cost of the debt is computed as follows: $10,000 paid to the lender minus $3,000 of income tax savings equals a net cost of $7,000 per year on the $100,000 loan. This means the after-tax cost is 7% ($7,000 divided by $100,000) per year.
Using the example above, the after-tax interest rate can also be calculated. The formula for the after-tax rate is: the loan interest rate of 10% minus (30% tax savings on the 10% interest rate) = 10% minus 3% = 7%.