After Tax cost of Debt

What is After tax cost of debt ?

After tax cost of debt is the pre-tax cost of debt adjusted for taxes. It is arrived at by deducting tax savings from pre-tax cost of debt. After tax cost of debt is used in the calculation of weighted average cost of capital.

 

How do you calculate After tax cost of debt ?

The formula for calculating the After tax cost of debt is

After tax cost of debt = Kd * ( 1 – T )

Where  Kd = Pre-tax cost of debt    ;   T = Tax rate   ;

 

What is Interest tax shield ?

Interest tax shield is the savings in the amount of tax payable, due to the deduction of Interest expense in arriving at taxable profit. This can be explained with the help of the following example.

 Consider X Inc. having an outstanding debt of $ 20,000, procured at an interest rate of 10 %, reports a profit of $ 50,000 during the current year. The tax rate applicable to the company is 25 %.

Now the interest expense on the debt is = $ 20,000 * 10 % = $ 2,000. This amount is deducted from the current year profit to arrive at the taxable profit.

Thus taxable profit = $ 50,000 – $ 2,000 = $ 48,000. The corresponding tax is = $ 48,000 * 25 % = $ 12,000

Now assume Interest in not allowed to be deducted in the computation of taxable profit. Then the tax payable shall be $ 50,000 * 25 % = $ 12,500

Thus the tax savings due to deductibility of the Interest expense = $ 12,500 – $ 12,000 = $ 500

 

Interest tax shield can also be calculated as follows i.e.,

Interest tax shield = Interest expense * Tax rate = $ 2000 * 25 % = $ 500

 

Example :

Harold Inc. has an outstanding debt of $ 200,000. The interest rate of the debt incurred i.e, pre-tax cost of debt is 20 %. The applicable tax rate for the company is 35 %. Calculate the After tax cost of debt. ( Round the solution to two decimal places )

Solution :

The formula for calculating the After tax cost of debt is

After tax cost of debt = Kd * ( 1 – T )

 

As per the information provided in the question

Kd = 20 % = 0.20    ;    T  = 35 % = 0.35   ; 

Using the information provided in the formula we have the after tax cost of debt as

= 0.20 * ( 1 – 0.35 )

= 0.20 * 0.65

= 0.1300

= 13.00 %

Thus Harold Inc.’s After tax cost of debt = 13.00 %

 

 

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