The question is asking for the cost of the debt / interest after tax, interest on debt reduces our taxes. In simple terms, the actual interest to a company may be lower on an after-tax basis because interest payments are typically tax-deductible.
Cost of the debt / Interest = is an expense and it is deducted from income before we calculate taxes on that income
Cost of equity / Dividend – is not an expense. And it is not tax-deductibles, as we pay-out dividends after paying taxes and after net income.
However, when analyzing financial metrics or making financial decisions, it's common to consider the pre-tax cost of debt as a starting point before factoring in any tax advantages. This is because tax laws and rates can change, and it's important to have a baseline understanding of the cost of debt without relying on specific tax benefits.
So, total debts are 38m and interest on those debt is 2.93m.
Cost of the debt before taxes is 2.93m/38m = 7.710%
So, after tax income % would be 67% (1-tax rate)
Cost of the debt after taxes is 7.710% * 67% (0.0771*0.67) = 5.17%
I hope this should make the concept easy to understand!
------------------------------
SHAIBAN AHMED HAJI FAQUIH
Accountant
DUBAI
United Arab Emirates
------------------------------
Original Message:
Sent: 11-18-2019 10:00 PM
From: Syed Yousuf Jamal
Subject: cost of capital
A recent leveraged buyout was financed with $50M. This amount comprised partner's equity capital of $12M, $20M unsecured debt borrowed at 7% from one bank, and the remainder from another bank at 8.5%. What is the overall after-tax cost of the debt financing if you expect the firm's marginal tax rate to be 33%?
------------------------------
Syed Yousuf Jamal
------------------------------