how to calculate pre tax cost of debt
How to calculate pre tax cost of debt
This is a simple problem but I'm not sure about one aspect of it.
A company has 15 year bonds outstanding, with a 5% annual coupon, a face value of \$1000, and a current market value of \$1100. What is the company's pre-tax cost of debt?
I'm tempted to think it's just 5%, as when the company originally sold the bonds it received $1000 and is paying 5% coupons on that original face value, but the inclusion of the current market value is confusing me. I'd appreciate any help you can give me.
How to Calculate the Pre-tax Cost of a Debt
Cost of debt is what it costs a company to maintain debt. The amount of debt is normally calculated as the after-tax cost of debt because interest on debt is normally tax-deductible. The general formula for after-tax cost of debt then is pretax cost of debt x (100 percent - tax rate). The company will retain the non-taxed portion of the debt while the government taxes the taxable portion of the debt. For example, a company borrows $10,000 at a rate of 8 percent interest. The pre-tax cost of debt is then 8 percent.
Determine the company's tax rate and after-tax cost of debt. For example, a company's tax rate is 35 percent, and its after-tax cost of debt is 10 percent.
Write out the formula for after-tax cost of debt. In our example, 10 percent = pre-tax cost of debt x (100 percent - 35 percent).
Solve for the pre-tax cost of debt. In our example, pre-tax cost of debt equals 15.38462 percent.
How do you calculate pretax cost of debt?
after-tax-cost-of-debt = 10%*(1-0.35) = 6.5%
hope that answered your question
How do you calculate pretax cost of debt?
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Cost of debt refers to the effective rate a company pays on its current debt. In most cases, this phrase refers to after-tax cost of debt, but it also refers to a company's cost of debt before taking taxes into account. The difference in cost of debt before and after taxes lies in the fact that interest expenses are deductible.
Cost of debt is one part of a company's capital structure, which also includes the cost of equity. Capital structure deals with how a firm finances its overall operations and growth through different sources of funds, which may include debt such as bonds or loans, among other types.
The cost of debt measure is useful to understand the overall rate being paid by a company to use these types of debt financing. The measure can also give investors an idea of the company's risk level compared to others because riskier companies generally have a higher cost of debt.
How to Calculate the Cost of Debt
To calculate cost of debt, a company must figure out the total amount of interest it is paying on each of its debts for the year. Then, it divides this number by the total of all of its debt. The quotient is its cost of debt.
For example, say a company has a $1 million loan with a 5% interest rate and a $200,000 loan with a 6% rate. It has also issued bonds worth $2 million at a 7% rate. The interest on the first two loans is $50,000 and $12,000, respectively, and the interest on the bonds equates to $140,000. The total interest for the year is $202,000. As the total debt is $3.2 million, the company's cost of debt is 6.31%.
How to Calculate the Cost of Debt After Taxes
To calculate after-tax cost of debt, subtract a company's effective tax rate from 1, and multiply the difference by its cost of debt. Do not use the company's marginal tax rate; rather, add together the company's state and federal tax rate to ascertain its effective tax rate.
For example, if a company's only debt is a bond it has issued with a 5% rate, its pre-tax cost of debt is 5%. If its tax rate is 40%, the difference between 100% and 40% is 60%, and 60% of 5% is 3%. The after-tax cost of debt is 3%.
The rationale behind this calculation is based on the tax savings the company receives from claiming its interest as a business expense. To continue with the above example, imagine the company has issued $100,000 in bonds at a 5% rate. Its annual interest payments are $5,000. It claims this amount as an expense, and this lowers the company's income on paper by $5,000. As the company pays a 40% tax rate, it saves $2,000 in taxes by writing off its interest. As a result, the company only pays $3,000 on its debt. This equates to a 3% interest rate on its debt.
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The after-tax cost of debt is the initial cost of debt, adjusted for the effects of the incremental income tax rate. The formula is:
Before-tax cost of debt x (100% - incremental tax rate)
= After-tax cost of debt
For example, a business has an outstanding loan with an interest rate of 10%. The firm's incremental tax rates are 25% for federal taxes and 5% for state taxes, resulting in a total tax rate of 30%. The resulting after-tax cost of debt is 7%, for which the calculation is:
10% before-tax cost of debt x (100% - 30% incremental tax rate)
= 7% after-tax cost of debt
In the example, the net cost of debt to the organization declines, because the 10% interest paid to the lender reduces the taxable income reported by the business. To continue with the example, if the amount of debt outstanding were $1,000,000, the amount of interest expense reported by the business would be $100,000, which would reduce its income tax liability by $30,000.
The after-tax cost of debt can vary, depending on the incremental tax rate of a business. If profits are quite low, an entity will be subject to a much lower tax rate, which means that the after-tax cost of debt will increase. Conversely, as the organization's profits increase, it will be subject to a higher tax rate, so its after-tax cost of debt will decline.
The after-tax cost of debt is included in the calculation of the cost of capital of a business. The other element of the cost of capital is the cost of equity.