## 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%.