After-Tax Cost of Debt and How to Calculate It

After-Tax Cost of Debt and How to Calculate It

May 21, 2020 Bookkeeping 101 by ann

As the majority of businesses run on borrowed funds, the cost of capital becomes an important parameter in assessing a firm’s potential of net profitability. Analysts and investors use weighted average cost of capital(WACC) to assess an investor’s returns on an investment in a company. A company’s cost of debt is the effective interest rate a company pays on its debt obligations, including bonds, mortgages, and any other forms of debt the company may have.

A business needs to balance the use of debt and equity to keep the average cost of capital at its minimum. The rate of corporate tax that companies pay in the U.S. plays a major part in determining WACC because as tax rates go up, the WACC falls. Higher taxes impact the WACC calculation because a lower WACC is much more attractive to investors. First, consider the percentage of the company’s financing that consists of equity and multiply it by the cost of equity.

From the borrower’s (company’s) perspective, the cost of debt is how much it has to pay the lender to get the debt. This only considers the dividend yield component of the required return on equity. This is the current yield only, not the promised yield to maturity. In addition, it is based on the book value of the liability, and it ignores taxes.

Conversely, as the organization’s profits increase, it will be subject to a higher tax rate, so its after-tax cost of debt will decline. The cost of equity, then, is essentially the amount that a company must spend in order to maintain a share price that will satisfy its investors.

The after-tax cost of debt is the interest paid on debt less any income tax savings due to deductible interest expenses. To calculate the after-tax cost of debt, subtract a company’s effective tax rate from 1, and multiply the difference by its cost of debt.

Business Debt Factoring into After-Tax Cost of Debt

WACC is the average after-tax cost of a company’s various capital sources, including common stock,preferred stock,bonds, and any otherlong-term debt. In other words, WACC is the average rate a company expects to pay to finance its assets. For example, if a company’s only debt is a bond it has issued with a 5% rate, its pre-tax cost of debt is 5%. If its tax rate is 40%, the difference between 100% and 40% is 60%, and 60% of the 5% is 3%.

Then, take the percentage of current financing from debt, multiply by the cost of that debt and multiply the result by one, minus the effective marginal corporate tax rate. The weighted average cost of capital (WACC) is one of the key inputs in discounted cash flow (DCF) analysisand is frequently the topic of technical investment banking interviews. The WACC is the rate at which a company’s future cash flows need to be discounted to arrive at a present value for the business.

The company also needs to know the cost of debt or the return it can get on bonds it issues. WACC is essentially the average after-tax cost of attaining those sources of funding; it’s the average rate that the company can expect to pay to finance the assets that it has. We now turn to calculating the costs of capital, and we’ll start with the cost of debt.

Debt and equity are the two components that constitute a company’s capital funding. Lenders and equity holders will expect to receive certain returns on the funds or capital they have provided. Put another way, WACC is an investor’s opportunity cost of taking on the risk of investing money in a company. A high weighted average cost of capital, or WACC, is typically a signal of the higher risk associated with a firm’s operations.

How do you calculate after tax cost of debt?

The after-tax cost of debt is the interest paid on debt less any income tax savings due to deductible interest expenses. To calculate the after-tax cost of debt, subtract a company’s effective tax rate from 1, and multiply the difference by its cost of debt.

Put simply, if the value of a company equals the present value of its future cash flows, WACC is the rate we use to discount those future cash flows to the present. Finally, to calculate the after-tax cost of debt, simply subtract the company’s marginal tax rate from one and then multiply the result by the effective tax rate you found earlier. 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. The weighted average cost of capital (WACC) is a calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation.

Between equity financing and debt financing, businesses have an obligation to track their liabilities. With the many financing options available for businesses of all sizes, calculating the cost of debt can be complex. Review this step-by-step guide to the cost of business debt for an understanding of calculating the after-tax cost of debt.

The after-tax cost of debt is included in the calculation of the cost of capital of a business. Cost of debt is one part of a company’s capital structure, which also includes the cost of equity. Capital structure deals with how a firm finances its overall operations and growth through different sources of funds, which may include debt such as bonds or loans, among other types. The after-tax cost of debt is a quantitative measure of how much a business is paying for its debt financing. This information offers valuable financial insight and practical investment figures that businesses can use to improve their financial position.

  • As the majority of businesses run on borrowed funds, the cost of capital becomes an important parameter in assessing a firm’s potential of net profitability.
  • Analysts and investors use weighted average cost of capital(WACC) to assess an investor’s returns on an investment in a company.
  • A company’s cost of debt is the effective interest rate a company pays on its debt obligations, including bonds, mortgages, and any other forms of debt the company may have.

Commercial Real Estate Loans

Calculating the after-tax cost of debt is one way business owners can determine how much value their debt provides. Taxes can be incorporated into the WACC formula, although approximating the impact of different tax levels can be challenging. One of the chief advantages of debt financing is that interest payments can often be deducted from a company’s taxes, while returns for equity investors, dividends or rising stock prices, offer no such benefit. A company’s WACC can be used to estimate the expected costs for all of its financing. This includes payments made on debt obligations (cost of debt financing), and the required rate of return demanded by ownership (or cost of equity financing).

Why Does a Business Need to Calculate Their After-Tax Cost of Debt?

The after-tax cost of debt can vary, depending on the incremental tax rate of a business. If profits are quite low, an entity will be subject to a much lower tax rate, which means that the after-tax cost of debt will increase.

Debt can be a critical device for businesses that know how to calculate the costs and benefits accurately. It’s important to understand how debt impacts a company’s bottom line so businesses can optimize their financial strategy.

After-Tax Cost of Debt – How to Calculate it For Your Business

Even if the debt is publicly traded, an additional complication is when the firm has more than one issue outstanding; these issues rarely have the same yield because no two issues are ever completely homogeneous. The cost of debt is the effective interest rate a company pays on its debts. The cost of debt often refers to before-tax cost of debt, which is the company’s cost of debt before taking taxes into account.

It considers multiple variables though, so it’s not necessarily an accurate depiction of a firm’s total costs. Beyond the general benefits of calculating a company’s after-tax cost of debt, the information is critical to understanding how much a company pays for all of its capital. The pretax cost of debt is $500 for a $10,000 loan, but because of the company’s effective tax rate, their after-tax cost of debt is actually $150 for the same $10,000 loan. This makes a significant difference in a company’s total cost of capital.

after tax cost of debt calculator

Investors tend to require an additional return to neutralize the additional risk. Because all debt, or even 90% debt, would be too risky to those providing the financing.

With debt capital, quantifying risk is fairly straightforward because the market provides us with readily observable interest rates. For example, a company might borrow $1 million at a 5.0% fixed interest rate paid annually for 10 years.

Because interest expense is deductible, it’s generally more useful to determine a company’s after-tax cost of debt. Cost of debt, along with cost of equity, makes up a company’s cost of capital. There are tax deductions available on interest paid, which are often to companies’ benefit. Because of this, the net cost of a company’s debt is the amount of interest it is paying, minus the amount it has saved in taxes as a result of its tax-deductible interest payments. This is why the after-tax cost of debt is Rd (1 – corporate tax rate).

Equity is inherently more risky than debt (except, perhaps, in the unusual case where a firm’s assets have a negative beta). If taxes are considered in this case, it can be seen that at reasonable tax rates, the cost of equity does exceed the cost of debt. -The appropriate aftertax cost of debt to the company is the interest rate it would have to pay if it were to issue new debt today. Hence, if the YTM on outstanding bonds of the company is observed, the company has an accurate estimate of its cost of debt.

The company’s marginal tax rate is not used, rather, the company’s state and the federal tax rate are added together to ascertain its effective tax rate. The most difficult part of calculating WACC is determining a business’s equity costs. Due to some variables, including the stock market, this part is generally the estimate in the WACC calculation. That’s why the after-tax cost of debt is so critical to balancing WACC calculations. The weighted average cost of capital (WACC) is a calculation of how much a company should pay to finance the operation.

However, the difference in the cost of debt before and after taxes lies in the fact that interest expenses are deductible. If a business hands their financials over to an accountant, the accountant probably does this calculation for them. Calculating the after-tax cost of debt is something any business owner can and should do, though. Businesses that regularly leverage debt should already be calculating their after-tax cost of debt, but not every business is aware of the practical benefits of understanding the actual costs of debt financing. When looking at individual financing offers, it can be easy to focus on the cost of that particular piece of debt rather than the whole portfolio.

For the purposes of the after-tax cost of debt, the effective tax rate is determined by adding the company’s federal tax rate and its state tax rate together. Depending on the state, that means some businesses may not have a federal or a state tax rate. The primary benefit of calculating the after-tax cost of debt is knowing how much a business can save on its taxes due to the interest it paid over the year. This means businesses need to know their effective tax rate to understand their total cost of debt.

byann