tax shield
http://termsexplained.com/448626/after-tax-cost-of-debt
Example
iQ systems has earnings before interest and taxes of $200 million. It has interest-bearing debt of $50 million carrying 8% interest rate. The company's marginal tax rate is 35%. Find the after tax cost of debt in dollar and in percentage.
Solution
Cost of debt (i.e. interest expense) is $4 million (=$50 million × 8%).
Earnings before taxes = $200 million − $4 million = $196 million
Tax expense = $196 million × 35% = $68.6 million
Net income = $196 million × (1 − 35%) = $196 million − $68.6 million = $127.4 million
If there were no debt, there would be no interest expense, and tax expense would be $70 million (=$200 million × 35%)
no problem in understanding this IF STATEMENT
Existence of debt reduced tax expense by $1.4 million (= $70 million − $68.6 million) and this is the interest tax shield.
no problem in understanding this
The true cost of debt i.e. the after tax cost of debt = total cost of debt − interest tax shield = $4 million − $1.4 million = $2.6 million
so which amount does the company actually pay $4 million or $2.6 million? Assuming no deferred or capitalized interest
In percentage terms, the after tax cost of debt = 8% × (1 − 35%) = 5.2%. This precisely equals the ratio of after tax interest expense in dollars to the principal balance of debt (i.e. $2.6 million/$50 million = 5.2%).
You would pay the $4MM to your creditor as an interest expense. The after-tax cost of debt just means that by incurring that $4MM of interest expense, you gain a $1.4MM decrease in your year-end tax bill, and the amount you pay is netted with the tax savings to produce the $2.6MM.
i know we save the $1.4 million in taxes AFTER paying the creditor $4 million because the interest cannot be taxed... but what is the purpose of the $2.6 million? because we save $1.4 and pay $4million ... in other words WHY do we $4million - $1.4million? What are we trying to convey with the $2.6million
the 2.6MM is essentially the cost for you to employ that $50MM of debt financing in the current year.
You pay 4mm in interest expense but since your pre-tax income is lower you actually pay less taxes which is where you save the 1.4mm.
thanks .. but that was not the question ... the question is:-
additionally when you say
CorpFinHopeful: the 2.6MM is essentially the cost for you to employ that $50MM of debt financing in the current year.
doesn't that mean that the $2.6 million could have been for something else than acquiring debt, preventing us from paying the $4 million and also preventing us from getting a $1.4 million tax saving ....
so in other words the trade off (opportunity cost) is between $1.4 million of tax saving AND $2.6 million for acquiring debt? am i correct?
because logically the cost of capital is an opportunity cost
It is a confusing concept. Differentiating between implicit and explicit costs would be helpful. The argument is that when you offset your nominal cost of debt ($4M) with the tax savings ($1.4M), your true cost of debt (ie "economic outflow" as someone earlier stated) is reduced: specifically to (1 - T)interest expense, so in this case (1-35%)4M=2.6M.
From a practical standpoint, it can be confusing to grasp why an equity investor would prefer layering on debt and incurring the above scenario as opposed to just paying taxes with zero debt. Having zero debt and paying out $70M on $200M to take home $130M would seem preferable to paying a creditor $4M combined with a reduced tax bill of $68.6M for a grand total of $72.6M and taking home $127.4.
However, from that equity investor's standpoint your investment basis is lower when you can incorporate debt into the capital structure, so the incrementally lower net income is greater from a returns standpoint. For example, if this company had a total capitalization of $500M the return to equity holders without debt would be 26%=$130M/$500M=net income/equity=net income/total capitalization. Holding the total capitalization constant at $500M, if you were able to layer on $50M of debt you would reduce your equity basis to $450M. As a result, your returns would be 28.3%=$127.4M/$450M=net income/equity=net income/(total capitalization - debt).
In short, incurring debt allows you to effectively decrease your tax liability, but the business will produce less net income since you now have to pay interest to a creditor. All things considered though, increasing leverage will allow the equity investor to receive a higher return on investment.
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