Question

Why is tax rate deducted while calculating cost of debt?

Answer 1

Answer:

It equals pre-tax cost of debt multiplied by (1 – tax rate). It is the cost of debt that is included in calculation of weighted average cost of capital (WACC). ... The effect of this deduction is a reduction in taxable income and resulting reduction in income tax

Explanation:

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Answer 2

After-tax cost of debt is the net cost of debt determined by adjusting the gross cost of debt for its tax benefits. It equals pre-tax cost of debt multiplied by (1 – tax rate). It is the cost of debt that is included in calculation of weighted average cost of capital.

Tax laws in many countries allow deduction on account of interest expense. The effect of this deduction is a reduction in taxable income and resulting reduction in income tax. The reduction in income tax due to interest expense is called interest tax shield. Due to this tax benefit of interest, effective cost of debt is lower than the gross cost of debt.

Formula

After-tax cost of debt can be determined using the following formula:

After-Tax Cost of Debt

= Pre-Tax Cost of Debt × (1 – Tax Rate)

The gross or pre-tax cost of debt equals yield to maturity of the debt. The applicable tax rate is the marginal tax rate. When the debt is not marketable, pre-tax cost of debt can be determined with comparison with yield on other debts with same credit quality.

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