After-tax cost of debt is an amount to be paid after adjustments to income are applied. The after-tax cost of debt is very important because the income tax that the company pays will be low since if they have a loan, a part of their interest will be deducted from taxable income.
So, the cost of debt is crucial because it gives the company the opportunity to save taxes. When borrowing money to issue bonds, the company must give a fixed interest rate to the investor who invested in their bonds. It should be borne in mind that it differs from cost before taxes for those components whose fees are exempt from taxable profit (interest). After-tax cost of debt is lower than before taxes due to tax shelter-tax savings.
The debt cost formula can help you determine the actual cost of debt. It also helps companies to justify the cost of debt in the business. How does it work? Let’s check it out!
What is the after-tax cost of debt calculator?
After-tax cost of debt calculator is a tool that helps us check if a loan is profitable for business or not. It allows us to compare the cost of debt with the income generated by the amount of the loan in business.
The loan can be taken for several reasons, from issuing a bond to buying a machine, and the main reason for that is the generation of income and business growth. It also helps to know the cost of the company’s capital.
After-tax cost of debt formula
After-tax cost of debt = cost of debt * (1 -marginal corporal tax rate)
As mentioned above, the after-tax cost of debt formula can help you find out the actual cost of debt in addition to justifying the cost of debt. The cost of debt is the expected rate of return for the owner of the debt and is usually calculated as the effective interest rate applied to the liability of the enterprise.
It is an integral part of the discount assessment analysis. It is used to calculate the present value of the company by discounting future cash flows according to the expected rate of return on equity and debt.
Measuring the cost of debt can help you find the financial condition of the company. Based on that value, investors will decide on whether or not to invest in the company. Also, it allows you to find out the level of risk of your business. If the debt is high, then the risk will be high too.
Thus, the cost of debt is one of the main factors when it comes to tax rates and interest. This cost can help you determine the cost of interest, which is very important for taxation and tax deduction. This interest expense is used for the purpose of tax savings by the company and it is treated as an operating expense.
We will explain the notion of marginal corporal tax rate as a measure that shows how much the tax debt increases if the tax base is increased by one monetary unit.
Marginal corporate tax rate = 1 – (net income/pre-tax income)
Example:
Let’s say your pre-tax income is $1,500,000, while the net income is $1,000,000. The marginal corporate tax rate, in this case, will be 33.33%. If you have a 6% cost of debt, after we put all of these figures in the calculator, it will result in a 4% after-tax cost of debt.
Relevance and use of the after-tax cost of debt formula
There are multiple uses of the after-tax cost of debt formula, such as:
- It helps you to save taxes.
- It can make it easier for you to know the risk when it comes to running a business.
- This is an easy way to calculate the net income that the company generates using the loan amount.
- The after-tax cost of debt formula is a component of the WACC (Weighted average cost of capital).
- The cost of debt after tax can also be used to get a better understanding of the actual financial position of the company.
Ways to lower debt cost
There are many ways to reduce the cost of debt, including:
1. Getting a cheaper loan
This involves getting a loan at a lower interest rate, which can be achieved by creating a good credit result by repaying the loan on time, offering collateral, negotiating, etc.
2. Refinancing loan
First, you need to start a loan with an interest rate that suits your needs. When the business starts to grow, you should refinance your loan at a lower rate a few months after getting the loan.
3. Optimizing business growth
With the increase in business income, you should consider increasing your debt if you’re able to afford it. The cost of debt is compared to the income generated by the loan amount. By increasing operating income, the cost of debt can be reduced over time.
Cons of cost of debt
- The company is obliged to return the principal borrowed together with interest.
- Failure to repay the debt results in the collection of default interest.
- The firm may also be required to set aside cash / foreign currency for these payment obligations, which would affect the free cash flows available for their day-to-day operations.
- Non-payment of debt obligations would negatively affect the overall creditworthiness of the company as time goes on.
Limitations of the After-Tax Cost of Debt Calculator
The calculations do not take into account other costs incurred due to debt financing, such as credit insurance costs, fees, etc. The formula assumes that there was no change in the capital structure of the company during the period under review.
In order to understand the total rate of return on debt, the cost of interest of both creditors and current liabilities should also be taken into account. An increase in the company’s debt costs is an indicator of a higher risk associated with its operations.