How to Calculate Interest Expense After Tax on a Bond

How to Calculate Interest Expense After Tax on a Bond
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Governments usually issue bonds to fund public-interest projects, while companies issue corporate bonds to increase their capital to pay debts, expand their businesses and improve their cash flow. Most bonds pay interest twice a year until the maturity of the bond and are low risk compared to other kinds of securities.

Generally, corporate bonds that are high-risk tend to offer higher coupon rates, while those with associated lower risks offer lower interest rates. Further, U.S. savings bonds are usually considered some of the most stable debt securities. That’s because they are backed by the full faith and credit of the U.S. government.

How Companies Record Bonds

When companies issue bonds, they take on long-term debts because they are borrowing money from investors. To pay for that loan they obtain from investors, they typically must pay a specified amount of interest twice a year for the duration of the loan.

When the bond matures, they must return the principal back to the lenders. During the duration of the bond prior to maturity, companies must account for the interest expenses they incur paying the interest to investors within each accounting period.

Usually, when a company issues a bond, it creates a liability account known as bonds payable on its balance sheets. It shows it has committed to paying the principal amount in the future and interest on a semi-annual basis. For as long as the bond exists until it matures, companies must keep a record of bonds payable in the non-current liabilities section.

When a bond is issued at a premium or discount, the excess amount must be amortized over the life of the bond. And every six months, when coupon payments are issued, the company will incur an interest expense, which must be recorded in its income statement.

Formulas for Interest Expense Recording

The formula for the annual interest expense is:

Interest Expense = (Total Bond Value * Coupon Rate of Bond) + (Amortized Amount)

If the bond is issued at par value, the amortized amount will be zero.

However, companies also tend to record the after-tax interest expense. This refers to the interest a company pays on a debt after deducting its income tax savings.

The after-tax interest rate formula is:

After-Tax Interest Rate = (1 - Company’s Effective Tax Rate) * Bond Interest Rate

So, you can use that to get the after-tax interest expense in dollars by expanding the formula as follows:

After-Tax Interest Expense = Interest Expense *(1- Company’s Tax Rate)

Or the following:

After-Tax Interest Expense = Total Bond Debt*After Tax Interest Rate

How to Calculate Interest Expense After Tax on a Bond

Below are the steps you can take to calculate the after-tax interest expense on a bond.

  • Find out all the information you need concerning the company whose after-tax interest expense you want to calculate. For example, suppose Marine Engineering Works Ltd. issued a corporate bond worth $4 million paying a 10 percent interest rate with payments twice a year for 10 years. Also suppose there is no amortization on this bond and the company pays tax at a rate of 25 percent.
  • Determine the interest expense amount. In this case, that would be (($4 million*10)/100) + $0, which remains $400,000 per year for 10 years.
  • Use the correct formula to calculate the after-tax interest expense: Interest expense(1-.25), which is like $400,0000.75, which equals $300,000. Alternatively, you could use the formula: (1 - Company’s Effective Tax Rate) * Bond Interest Rate * Total Bond Debt. That is similar to 0.750.14 million. In this case, you would get 0.075*4,000,000, which is equal to $300,000.
  • The result you get after using the calculations shows the annual interest expense the company incurs each year for borrowing money via a bond.