Marginal corporate tax rate
Net income
$
Pre-tax income
$
After-tax cost of debt
Cost of debt
%
Marginal corporate tax rate
%
After-tax cost of debt
%

With this after-tax cost of debt calculator, you can easily calculate how much it costs a company to raise new debts to fund its assets.

After reading this article, you will understand what is the after-tax cost of debt and how to calculate the after-tax cost of debt. You will also understand how to apply the after-tax cost of debt formula to real-life situations.

What is the after-tax cost of debt?

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.

We define the cost of debt as the market interest rate, or yield to maturity (YTM), that the company will have to pay if it were to raise new debt from the market. Don't worry if this sounds technical, we explain in detail how you can obtain the cost of debt in the following section.

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.

How to calculate the after-tax cost of debt using the after-tax cost of debt formula?

There is no better way to understand the concept of the after-tax cost of debt than to see it applied in real life.

To facilitate this, let's assume that we are analyzing a hypothetical company, Bill's Brilliant Barnacles, with the following information:

  • The debt of Bill's Brilliant Barnacles has a credit rating of AA;
  • The debt of Bill's Brilliant Barnacles has a maturity of 15 years;
  • Pre-tax income of Bill's Brilliant Barnacles in 2020 was $1,000,000; and
  • Net income of Bill's Brilliant Barnacles in 2020 was $800,000.

To calculate the after-tax cost of debt, there are 3 steps you need to follow:

  1. Calculate the cost of debt

Determining a company's before-tax cost of debt, or the cost of debt, has always seemed difficult and complicated.

As we explained above, the cost of debt is the market interest rate, or yield to maturity (YTM), that the company will have to pay to its debtor to raise new debts from the market. However, more often than not, it is almost impossible to obtain the market interest rate of a particular company, especially when the company's debt is not publicly traded. So, how do we calculate the before-tax cost of debt of a company?

Worry not. There is still a way that we can obtain this information. And to do that, we need to know the credit rating and the maturity of the company's existing debt. In our example, the credit rating of Bill's Brilliant Barnacles' existing debt is AA and the maturity of its existing debt is 15 years.

Using these 2 pieces of information, we can estimate the company's before-tax cost of debt by comparing its debt to other publicly traded bonds with a similar credit ratings. For instance, if Charlie's Cheerful Cobblers, a company with debts of similar credit rating and maturity as Bill's Brilliant Barnacles, has an 8% yield to maturity (YTM) for its debt, we can safely assume that Bill's Brilliant Barnacles' before-tax cost of debt will be approximately 8% as well.

  1. Calculate the marginal corporate tax rate

There are 2 inputs that you need to calculate the marginal corporate tax rate, namely the company's pre-tax income and the company's net income.

You can calculate the marginal corporate tax rate using the formula below:

marginal corporate tax rate = 1 - (net income / pre-tax income)

As the corporate tax rate is applied to the pre-tax income, the equation above should give us the marginal corporate tax rate of Bill's Brilliant Barnacles, which is:

marginal corporate tax rate = 1 - ($800,000 / $1,000,000) = 1 - 0.8 = 0.2 = 20%.

  1. Calculate the after-tax cost of debt

Now that we have obtained the before-tax cost of debt and the marginal corporate tax rate, it is time to calculate the after-tax cost of debt. The after-tax cost of debt can be calculated using the after-tax cost of debt formula shown below:

after-tax cost of debt = before-tax cost of debt * (1 - marginal corporate tax rate)

Thus, in our example, the after-tax cost of debt of Bill's Brilliant Barnacles is:

after-tax cost of debt = 8% * (1 - 20%) = 6.4%

What are the benefits of calculating the after-tax cost of debt?

The benefits of finding the after-tax cost of debt (for example, with our after-tax cost of debt calculator) are:

  1. After-tax cost of debt assists us in making investment decisions

If you want to fund a project with debt, it is essential to make sure the after-tax cost of debt of funding the project is less than the project's rate of return. In other words, the after-tax cost of debt is the required rate of return of the project if the project is funded 100% by debt.

To earn a return from the project, the project's rate of return has to be more than the required rate of return, which is the after-tax cost of debt.

  1. After-tax cost of debt helps us to assess the riskiness of a company

Calculating the after-tax cost of debt is also useful in assessing the riskiness of a company. If the company's after-tax cost of debt is a lot higher than the market average, it reflects that the investors require a higher return from the company. This means that the company is riskier compared to similar companies in the market.

  1. After-tax cost of debt is used in calculating the weighted-average cost of capital (WACC)

Last, but not least, the after-tax cost of debt is also an important part of calculating the WACC, which is made up of the after-tax cost of debt, cost of equity, and the company's capital structure.

In a nutshell, calculating the after-tax cost of debt is essential when assessing companies and projects. It can tell you how risky a company is and how much return you need for a project to be profitable. It is thus very crucial to understand what is the after-tax cost of debt and how to find the after-tax cost of debt.

However, the cost of debt is by no means the only metric to consider when assessing different projects and companies. So, it is recommended to form an overview of the company and ensure that every other metric is aligned before you make an investment decision.

Wei Bin Loo
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