(155)---COST OF CAPITAL - COST OF DEBT TAX ADJUSTMENT

Cost of Capital – Cost of Debt Tax Adjustment

The Interest paid on debts is tax deductible. The higher the interest charges, the lower will be the amount of tax payable by the firm this implies that the government indirectly pays a part of the lender’s required rate of return. As a result of the interest tax shield, the after tax cost of debt to the firm will be substantially less than the investor’s required rate of return. The before tax cost of debt, Kd should, therefore be adjusted for the tax effect as followers:

After tax cost of debt = Kd (1-T)

Where T is corporate tax rate. If the before tax cost of bond in our example is 16.6%, and the corporate tax rate is 35% the after tax cost of bond will be:

Kd = 0.165 (1-0.35) =0.1073 = 10.73%

It should be noted that the tax benefit of interest deductible would be available only when the firm is profitable and is paying taxes. And unprofitable firm is not required to pay any taxes. It would not gain any tax benefit associated with the payment of interest, and its true cost of debt is the before tax cost.

It is important to remember that in the calculation of the average cost of capital, the after tax cost of debt must be used not the before tax cost of debt.