Let’s imagine that you want to open your lemonade stand this summer. So you go and borrow $1,000 to help with initial costs.
You borrow at an annual interest rate of 5%, so your yearly interest expense is $50.
You will love to know that interest expense is tax deductible when paying taxes. But what is the actual cost of this debt?
This is where the after-tax cost of debt calculator comes in super handy. It simplifies this calculation by incorporating all the variables into an easy-to-use tool. Fill in your net income, pre-tax income, and annual interest rate of debt.
After-Tax Cost of Debt Definition
The after-tax cost of debt is the net cost to your company for taking on debt financing after accounting for tax deductions.
Debt can often be a tax-advantageous form of financing because interest expenses may be deductible from your taxable income, reducing the cost of borrowing.
The after-tax cost is typically lower than the debt’s pre-tax or nominal interest rate.
How to Calculate After-Tax Cost of Debt
To calculate the after-tax cost of debt, you can use the following formula:
After-Tax Cost of Debt = Pre-Tax Cost of Debt * (1 - Marginal Tax Rate)Where:
- Pre-tax cost of Debt is the annual interest rate your business pays on its debt.
- Marginal Tax Rate is the rate at which your next dollar of taxable income would be taxed. It includes federal, state, and sometimes local taxes.
To calculate the marginal tax rate, use the following formula:
Marginal Tax Rate = 1 - (Net Income / Pre-tax Income)Example Calculation
Imagine your business took out a loan with an annual interest rate of 6%, and your marginal corporate tax rate is 30%. Here’s how you’d calculate your after-tax cost of debt:
- Pre-tax cost of Debt (annual interest rate): 6%
- Marginal Tax Rate: 30%
After-Tax Cost of Debt = 6% × (1 - 0.30) = 6% × 0.70 = 4.2%This means that, after considering the tax benefit, the effective interest rate on your loan would be 4.2% rather than the 6% stated rate. Make sure to incorporate these calculations into your financial planning and when assessing your business’s overall cost of capital.