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After-Tax Cost of Debt
The XYZ Inc.’s currently outstanding bonds have a 10 percent yield to maturity and an 8 percent coupon. It can issue new bonds at par that would provide a similar yield to maturity. If its marginal tax rate is 40 percent, what is XYZ’s after-tax cost of debt?
What Is the Cost of Debt?
The cost of debt is the effective interest rate that a company pays on its debts, such as bonds and loans. The cost of debt can refer to the before-tax cost of debt, which is the company’s cost of debt before taking taxes into account, or the after-tax cost of debt. The key difference in the cost of debt before and after taxes lies in the fact that interest expenses are tax-deductible.
Impact of Taxes on Cost of Debt
Since interest paid on debts is often treated favorably by tax codes, the tax deductions due to outstanding debts can lower the effective cost of debt paid by a borrower. The after-tax cost of debt is the interest paid on debt less any income tax savings due to deductible interest expenses. To calculate the after-tax cost of debt, subtract a company’s effective tax rate from 1, and multiply the difference by its cost of debt. The company’s marginal tax rate is not used; rather, the company’s state and federal tax rates are added together to ascertain its effective tax rate.
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