Question

Company A has an aftertax cost of debt of 5.1 per cent at its current tax rate of 34 per cent. What will its aftertax cost of debt be if the tax rate drops to 21 per cent? Assume all interest is tax deductible. Explain the effect of taxes on the cost of capital.

Answer 1

After tax cost of debt = Before tax cost of debt(1 - tax)

0.051 = Before tax cost of debt (1 - 0.34)

0.051 = Before tax cost of debt0.66

Before tax cost of debt = 0.0773 or 7.73%

If tax rate changes to 21%

After tax cost of debt = Before tax cost of debt (1 - tax)

After tax cost of debt = 0.0773 (1 - 0.21)

After tax cost of debt = 0.0611 or 6.11%

After tax cost of debt is a component in calculating cost of capital. Cost of capital is basically the weighted average cost of raising funds using debt, equity and preferred stock. As the tax increase, after tax cost of debt will decrease, which in turn will decrease cost of capital.