Most businesses deduct their paid interest expenses from their taxable income on their income tax returns, allowing them to reduce the actual cost of their company’s debt. But companies sometimes present the after-tax cost of debt without acknowledging the before-tax cost. That may be effective for the current year, but the company could lose the tax benefits and have to pay full cost without receiving those tax benefits if the tax code changes going forward.
You’ll, therefore, need the before-tax cost of debt as well. You must identify the after-tax cost of debt and the income tax rate for the company in question to accurately calculate the before-tax cost.
Before-Tax Debt vs. After-Tax Debt
Taxes have a significant impact on the financial health of a company, so debts are typically divided into two categories: before-tax and after-tax. Before-tax debt doesn't take taxes into consideration. The after-tax cost of debt does. The after-tax cost of debt formula is effectively the amount of interest paid minus tax-deductible annual interest.
The after-tax cost is more representative of the company’s cost of debt because interest payments and a company’s total interest expense are usually tax deductible, according to the CFA Institute. After-tax cost of debt accounts for tax savings.
You'll Need Debt Data
You'll need information on the specific debt and the company’s current tax rate to get started with your cost of debt formula. Often this information is well documented in a company's financial statements. You can sometimes pull the information you’ll need directly from these statements because they'll reflect the exact interest the company paid on their debts in a given timeframe rather than an average interest rate.
You may also be able to pull the information from a business's cash flow statements because they'll often detail pretax money movements there. The after-tax metrics can be saved for their income statements.
Calculating Before-Tax Debt
Divide the company's effective tax rate by 100 to convert to a decimal. Its marginal tax rate isn't used in the calculation.
The actual federal and state tax rates are used together to pin down its effective tax rate: what it actually pays. The federal corporate tax rate was 21 percent in the final quarter of 2022, according to the Tax Foundation, an independent tax policy nonprofit. Forty-four states and Washington, D.C., also tax corporate income at rates ranging from 2.5 to 11.5 percent.
Let's assume that a company's total effective tax rate is 29 percent. Divide 29 by 100 to get 0.29. Subtract the company's tax rate expressed as a decimal from 1. In this example, subtract 0.29 from 1 to get 0.71.
Divide the company's after-tax cost of debt by the result to calculate the company's before-tax cost of debt. In this example, if the company's after-tax cost of debt equals $830,000, you'll then divide $830,000 by 0.71 to find a before-tax cost of debt of $1,169,014.08.
You can then backtrack to show the difference side by side if you need the after-tax cost as well. You can also express this number as a percentage by dividing the pretax cost of debt by total debt outstanding.
Implications of Your Data
Chances are there’s a reason if you're pulling this information regarding the total cost of debt. The data can be essential to moving a business forward. You may be able to see where your business can cut back and save significant money if you go through the balance sheets and calculate the pretax cost of debt for various items.
This information is also critical to lenders and debtholders, according to the Corporate Finance Institute. Cost of debt predicts a borrower’s ability to repay its creditors and debtholders and measures the risk they're undertaking by extending funds, a risk that’s not necessarily fully reflected in the company’s credit rating.
This can be especially important if yours is a small business that’s looking for a business loan or even just applying for a credit card, although it more frequently comes into play with sizeable lending and debt financing.
Cost of debt also includes the effective interest rate that a company must pay on the market value of bonds because bonds are effectively loans made by investors to the corporation when they buy them. They carry an interest rate as well. Assume a company has only one debt, a bond issued at a 6 percent rate. Its pretax cost of debt is just that, in this case: 6 percent.
This article was written by PocketSense staff. If you have any questions, please reach out to us on our contact us page.