The after-tax cost of debt is the interest rate on the debt multiplied by (100% minus the incremental income tax rate).
For instance, if a corporation's debt has an annual interest rate of 10% and the corporation's combined federal and state income tax rate is 30%, the after-tax cost of debt is 7%. The computation is: [10% interest rate X (100% minus 30% tax rate)] = [10% X 70%] = 7%.
Here is the example in dollars. 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).
