The after-tax cost of debt is the initial cost of debt, adjusted for the effects of the incremental income tax rate. The formula is:
Before-tax cost of debt x (100% - incremental tax rate)
= After-tax cost of debt
For example, a business has an outstanding loan with an interest rate of 10%. The firm's incremental tax rates are 25% for federal taxes and 5% for state taxes, resulting in a total tax rate of 30%. The resulting after-tax cost of debt is 7%, for which the calculation is:
10% before-tax cost of debt x (100% - 30% incremental tax rate)
= 7% after-tax cost of debt
In the example, the net cost of debt to the organization declines, because the 10% interest paid to the lender reduces the taxable income reported by the business. To continue with the example, if the amount of debt outstanding were $1,000,000, the amount of interest expense reported by the business would be $100,000, which would reduce its income tax liability by $30,000.
The after-tax cost of debt can vary, depending on the incremental tax rate of a business. If profits are quite low, an entity will be subject to a much lower tax rate, which means that the after-tax cost of debt will increase. Conversely, as the organization's profits increase, it will be subject to a higher tax rate, so its after-tax cost of debt will decline.
The after-tax cost of debt is included in the calculation of the cost of capital of a business. The other element of the cost of capital is the cost of equity.