Do Companies Measure Their Cost of Debt With Before- Or After-tax Returns?

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.

For example, assume two different banks offer otherwise identical business loans at interest rates of 4% and 6%, respectively. Using the pretax definition of cost of capital, it is clear that the first loan is the cheaper option because of its lower interest rate.

Depending on the context of the calculation, however, businesses often look at the after-tax cost of debt capital to gauge its impact on the budget more accurately. Payments on debt interest are typically tax-deductible, so the acquisition of debt financing can actually lower a company's total tax burden.

The most common utilization of this method is in the calculation of the weighted average cost of capital (WACC). The WACC formula is used by businesses to determine the average cost per dollar of all capital, both debt and equity, after taking into account the proportion of total capital each source represents. In the WACC formula, the cost of debt is calculated as

 Cost of debt = R ( 1 T ) where: R = The interest rate T = The corporate tax rate \begin{aligned} &\text{Cost of debt} = R*\left(1-T \right )\\ &\textbf{where:}\\ &R = \text{The interest rate}\\ &T = \text{The corporate tax rate}\\ \end{aligned} Cost of debt=R(1T)where:R=The interest rateT=The corporate tax rate

By multiplying the pretax cost of debt (represented by the interest rate) by the inverse of the tax rate, this formula gives a more realistic picture of the expense necessary to fund operations with debt.

Assume the corporate tax rate is 30% in the above example. The first loan has an after-tax cost of capital of 0.04 * (1 - 0.3), or 2.8%. The second loan has an after-tax cost of 0.06 * (1 - 0.3), or 4.2%. Clearly, the after-tax calculation does not affect the original decision to pursue the first loan, as it is still the cheapest option. When comparing the cost of the loan to the cost of equity capital, however, the incorporation of the tax rate can make a world of difference.

Article Sources

Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. Internal Revenue Service. "Publication 535," Page 14. Accessed April 15, 2021.

Take the Next Step to Invest
×
The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.
Service
Name
Description