Cost of Debt Question
For Cost of Debt, you say Cost of Debt = interest rate *(1- tax rate)
Why is it only part of the expense tax-deductible? Shouldn't we be able to take out the entirety of the expense when doing taxes?
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Interest payments lower taxable income. This basic number example should help to understand the concept of this tax shield:
Debt: 100 Interest rate: 5% Interest expense: 5
EBIT: 100 EBT: 95
Tax rate: 40%
Tax on EBIT: 40 Tax on EBT: 38
Implied interest expense: 5-(40-38) = 3 Implied interest rate: 3/100=3% or 5% * (1-40%) = 3%
Great answer. Think of it as a COST (sorry for caps, trying to make a point).
You are being charged, say, 5% interest rate. At a 20% Tax Rate, your net cost is 4% because you save the 1% in taxes that you would have had to pay.
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