How to Calculate After-Tax Cost of Debt

Once the company has its total interest paid for the year, it divides this number by the total of all of its debt. This formula is useful because it takes into account fluctuations in the economy, as well as company-specific debt usage and credit rating. If the company has more debt or a low credit rating, what is a ledger account then its credit spread will be higher. BNP Paribas, the euro zone’s biggest bank, beat estimates in the second quarter as the corporate debt financing business and strong cost management partly offset a slump in securities trading. The fed funds rate sets what banks charge each other for overnight lending.

The average of the unlevered betas is then calculated and re-levered based on the capital structure of the company that is being valued. These tools make it easier for businesses to thrive, but they come with a cost. An example of this is a business with a federal tax rate of 20% and a state tax rate of 10%. The pretax cost of debt is 5%, or 0.05, and the business has a $10,000 loan. 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.

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For the next section of our modeling exercise, we’ll calculate the cost of debt but in a more visually illustrative format. Provided with these figures, we can calculate the interest expense by dividing the annual coupon rate by two (to convert to a semi-annual rate) and then multiplying by the face value of the bond. As a preface for our modeling exercise, we’ll be calculating the cost of debt in Excel using two distinct approaches, but with identical model assumptions.

• The first approach is to look at the current yield to maturity or YTM of a company’s debt.
• Using the example, imagine the company issued $100,000 in bonds at a 5% rate with annual interest payments of $5,000.
• However, the problem with debt financing is that it increases leverage and signals the financial instability of the business if in excess.
• Although debt is not viewed as a financial asset, it is possible to use it as a tool to grow a business.
• The risk-free rate is the return that can be earned by investing in a risk-free security, e.g., U.S.

However, if there is information that the firm’s capital structure might change in the future, then beta would be re-levered using the firm’s target capital structure. WACC is used in financial modeling as the discount rate to calculate the net present value of a business. Their pre-tax cost of debt is 10% of 150,000 (150,000 multiplied by .10), which is $15,000.

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If a borrower has the backing of pledged assets, its cost of debt will be lower as compared to unsecured loans without a pledge. International credit rating agencies like Moody’s, S&P, and Fitch provide credit ratings of debt instruments issued by public companies. A business can use the dividend valuation model to determine its after-tax cost of debt.

Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

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There are a multitude of funding opportunities for businesses, from small business loans to lines of credit to equity financing and more. When they can accurately evaluate the risks and benefits to holding debt, companies can use debt strategically to finance growth. There are mainly two sources to raise the finance that include debt and equity. When the business opts for debt financing, it has to pay interest and the interest paid on the debt financing is tax allowable that leads to savings in the tax expense.

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. However, when this concept is applied in real-life, where tax needs to be accounted for, the after-tax cost of debt is more commonly used. The main reason for this is because the interest paid on debt is often tax-deductible. Using the “IRR” function in Excel, we can calculate the yield-to-maturity (YTM) as 5.6%, which is equivalent to the pre-tax cost of debt.

The total cost of interest before tax is $124,000 ($100,000+$24,000) and debt balance is $2,400,000 ($4,000,000+$400,000). The downturn of BNP’s corporate and institutional banking (CIB) unit follows a streak of outperforming results in the field and resulted from high volatility in the markets. Along with the rate hike, the committee indicated it will continue to cut the bond holdings on its balance sheet, which peaked at $9 trillion before the Fed began its quantitative tightening efforts. The balance sheet is now at $8.32 trillion as the Fed has allowed up to $95 billion a month in maturing bond proceeds to roll off.

This method can be applied across different debt types for the business. The after-tax cost of debt excludes the interest component because the interest paid on debt is a tax-deductible expense. There is no better way to understand the concept of the after-tax cost of debt than to see it applied in real life. Before we dive into the concept of the after-tax cost of debt, we must first understand what is the cost of debt and the cost of debt formula. With that said, the cost of debt must reflect the “current” cost of borrowing, which is a function of the company’s credit profile right now (e.g. credit ratios, scores from credit agencies). For example, a bank might lend $1 million in debt capital to a company at an annual interest rate of 6.0% with a ten-year term.

Before-Tax Cost of Debt

The risk-free rate is the return that can be earned by investing in a risk-free security, e.g., U.S. This is a good time to put together other debt information that can be helpful for future comparisons. Include the debt’s term, cost of additional fees, maturity date, and any other benefits the debt offers to the business. Businesses make payments toward their balance to free up credit for future purchases. Revolving credit can range from relatively inexpensive to extremely costly, but it is readily available to businesses. In general, this is a relatively low-risk investment opportunity for firms that have substantial capital and want to see steady, stable returns.

It’s not uncommon for the general population to view debt as an unfavorable financial instrument, but entrepreneurs and finance directors know the value of leveraging capital. In fact, smart business owners know how to use debt as an actual tool to grow their business. Cost of debt is most easily defined as the interest rate lenders charge on borrowed funds. When comparing similar sources of debt capital, this definition of cost is useful in determining which source costs the least.

That yield spread can then be added to the risk-free rate to find the cost of debt of the company. This approach is particularly useful for private companies that don’t have a directly observable cost of debt in the market. The first approach is to look at the current yield to maturity or YTM of a company’s debt. If a company is public, it can have observable debt in the market. An example would be a straight bond that makes regular interest payments and pays back the principal at maturity. The cost of debt measure is helpful in understanding the overall rate being paid by a company to use these types of debt financing.

This expense can refer to either the before-tax or after-tax cost of debt. The degree of the cost of debt depends entirely on the borrower’s creditworthiness, so higher costs mean the borrower is considered risky. After-tax cost of debt is the net cost of debt determined by adjusting the gross cost of debt for its tax benefits. It is the cost of debt that is included in calculation of weighted average cost of capital (WACC).

However, it’s considered an expensive source of financing as payment of a dividend does not tax allowable. However, the problem with debt financing is that it increases leverage and signals the financial instability of the business if in excess. Debt is one part of their capital structures, which also includes 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. Tax laws in many countries allow deduction on account of interest expense.

The first and simplest way is to calculate the company’s historical beta (using regression analysis) or just pick up the company’s regression beta from Bloomberg. A firm’s Weighted Average Cost of Capital (WACC) represents its blended cost of capital across all sources, including common shares, preferred shares, and debt. The cost of each type of capital is weighted by its percentage of total capital and they are added together.