Question

Why is the after-tax cost of debt more relevant compared to the nominal before-tax cost of debt in computing a firm’s cost of capital?

Answer 1

Cost of capital refers to the opportunity cost of investing a specific amount in a project, financial instruments etc. In computing a firm's cost of capital, after-tax cost of debt is more relevant compared to the nominal before-tax cost of debt as interest payments are tax deductible expenses, firms save capital on interest payments according to the tax slab applicable to the firm. As the firm saves capital in paying interest, these should not be included in opportunity cost because this amount of capital is already saved and will not help in capital budgeting analysis to know accurately which project or financial instrument is more beneficial to the firm.