What is the After-Tax Cost of Debt and How to Calculate It?

The after-tax cost of debt is the effective interest rate adjusted for the corporate tax paid by a borrower. It helps a company understand the impact of tax on its borrowings.

Let’s understand what is the after-tax cost of debt and how to calculate it.

What is the After-Tax Cost of Debt?

The cost of debt refers to the effective interest rate paid by a borrower on its debt instruments. It is the total cost of borrowings for a borrower.

Since a borrower can have different types of debt instruments, the cost of debt for each component will be different. Thus, calculating a uniform cost of debt is essential to estimate the effective interest rate paid by the borrower.

The after-tax cost of debt excludes the interest component because the interest paid on debt is a tax-deductible expense.

Conversely, we can define the cost of debt as the required rate of return by lenders and creditors. It is the rate of compensation paid by a borrower to its lenders.

How Does After-Tax Cost of Debt Work?

The cost of debt is essentially an estimation of the total interest paid by the borrower to its lenders. It’s important to calculate for a borrower to reflect its effective borrowing rate.

The after-tax cost of debt then adjusts for the corporate rate effects. It helps a borrower understand savings through debt financing.

It is the tax deduction of the interest expense that makes debt financing cheaper than equity financing. This is the primary reason businesses go for debt financing over equity financing in most cases.

The cost of debt then becomes an integral part of the total cost of capital calculations along with the cost of equity of a business.

How to Calculate Cost of Debt?

The cost of debt can be calculated in a few different ways. Let’s discuss some of these commonly used methods.

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The Dividend Valuation Method

A business can use the dividend valuation model to determine its after-tax cost of debt. This method can be applied across different debt types for the business.

The general formula to calculate the post-tax cost of debt is:

After-Tax Cost of Debt = Kd (1 – Tax Rate)

If the company’s debt (bonds) is irredeemable, then it can also use this formula by using the fair market value of the debt.

Kd (1-T) = I (1-T) / MV

For redeemable debt, the formula can be adjusted against the internal rate of return (IRR):

Kd (1-T) = IRR

The only drawback of this method is its difficulty in calculating different components and it’s valid for businesses with bonds or established debt instruments.

Debt Rating Method

International credit rating agencies like Moody’s, S&P, and Fitch provide credit ratings of debt instruments issued by public companies.

Similarly, many firms provide credit ratings of private firms as well. If there is no credit rating available, a company can match the credit rating of a public company and spread to determine its cost of debt.

The spread is also called risk-premium. The company should use a similar debt structure and industry when comparing its credit rating with a public company.

The formula to calculate the after-tax cost of debt through this method is:

Kd (1-T) = (Risk free rate + Credit spread) (1-T)

The Yield to Maturity Method

Another useful method to calculate the after-tax cost of debt is to use the yield-to-maturity formula. It is useful for private companies to have a simple debt structure.

The YTM method is widely used by companies with no debt trenches or different classes of debt in their debt mix.

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We can use the discounted cash flow (DCF) approach by using the present value formula to calculate the YTM of the debt instrument. Then, it can be adjusted for the tax impact of the post-tax cost of debt.

PV of Bond = Coupon/(1+r) ^1+ Coupon /(1+r) ^2+…. + Coupon /(1+r) ^n+ FV/(1+r) ^n

Solving this equation for “r” which is the yield to maturity of the bond will give the cost of debt.

Then, multiplying the value of “r” by (1- Effective Tax Rate) will give us the post-tax cost of debt.

Cost of Debt – Simple Method

Another useful method to estimate the cost of debt is by adding the total cost of debt manually for each debt instrument. It is simply the interest amount paid on each debt.

Then, you can add the fair values of all debt instruments till that date. Finally, divide the interest cost by the total debt amount and multiply it by a hundred to calculate the cost of debt.

The formula to calculate the cost of debt will be:

Cost of debt = (Total interest / total debt) × 100

The after-tax cost of debt will be:

After-Tax Cost of Debt = Cost Debt × (1 – Effective Tax Rate)

Example

Suppose a company ABC Co. Has three different types of debt instruments. It pays different interest rates on these debts.

Commercial Loan = $ 100,000 at 6%

Credit Card = $8,000 at 26%

Merchant Cash Advance = $ 35,000 at 23%

First, we’ll calculate the monthly interest payments on each debt instrument.

$100,000 × 6%= $6,000    

$8,000 ×26%= $2,080        

$35,000 × 23% = $8,050

Then add them:

Total Interest = $8,050 + $2,080 + $6000 = $ 16,130

Total Debt Value = $100,000 + $8,000 + $35,000 = $ 143,000

Cost of Debt = ($16,130/$143,000) × 100 = 11.27%

Now suppose ABC company pays corporate tax at an effective rate of 22%. Then, its post-tax cost of debt will become:

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Post-Tax Cost of Debt = Cost of Debt (1 – Effective Tax Rate)

Post-Tax Cost of Debt = 11.27% (1 – 22%) = 8.79%

What is the Impact of Tax on the Cost of Debt?

The interest expense of a business is a tax-deductible cost. It means the business can deduct interest paid on all of its debt from gross profits.

It will reduce the profit-before-taxes amount and the company will pay less amount of taxes. Thus, the company will save money on taxes.

The same impact reflects through the cost of debt calculations as well.

Considering our example above, if ABC company pays tax at 22% and its cost of debt is 8.79%, then, its interest payment would be: $ 143,000 × 11.27% = $ 16,116.

Now, the 22% tax means a saving of $12,569 × 22% = $ 3,547 on debt payments.

We can directly calculate the same by using the post-tax cost of debt rate as well, $143,000 × 8.79% = $12,569 which is $3,547 less.

How Does the After-Tax Cost of Debt Increase?

Several factors contribute to an increase in the cost of debt of a business.

The biggest factor is the creditworthiness of the borrower. When lenders consider an applicant risky, they demand a higher compensation rate and hence charge a higher interest rate on a loan.

Then, the amount of the loan and tenure also play crucial parts. Usually, the larger the amount and lengthier the maturity period the higher the interest rate charged by the lenders.

Finally, secured loans are less expensive than unsecured loans. If a borrower has the backing of pledged assets, its cost of debt will be lower as compared to unsecured loans without a pledge.