The after-tax cost of debt can be defined as the cost of financing from loans and debt securities, calculated with tax exemptions for debt servicing costs. Income tax paid by the company will be lower because the percentage of the debt will be deducted from taxable income, while dividends received by shareholders are not payable. As a result, the availability of debt reduces the company’s tax expenses.
Explanation:
The value of the borrowed capital is the value or price at which the enterprise has to pay for the attracted money. At the same time, raising debt capital is an additional opportunity to attract debt financing.
The enterprise, in various forms, can obtain such debt financing. For example, with the help of bank loans and overdrafts, bills of exchange, and other securities. Such funding may be raised at a fixed or variable (floating) interest rate, may or may not be secured by assets, guarantors, bank guarantees.
Speaking about the cost of borrowed capital, the following crucial fact should be considered. In contrast to income paid to shareholders, interest paid on borrowed money is included in the cost of production, including it is accounted for in the profit statement before income tax payment. Thus, the cost after-tax of borrowed capitalbecomes lower than the final yield (or value before tax).
The following formula for the after-tax cost of debt can be used for calculation.
After-Tax Cost of Debt = Pre-Tax Cost of Debt × (1 – Tax Rate)
For a more straightforward understanding, an example of calculating the after-tax cost of debt can be given. For instance, if the rate on corporate bonds is 6% and the income tax rate 20%, then the effective after-tax cost of debt will be 6(1-0.2) = 4.8%. The existence of debt reduces the amount of money to be taxed, which is a kind of interest protection.