Businesses need a lot of money to gear up and run. The owners often have to take loans or use credit cards for the smooth running of their operations.
The third-party lenders are not merely the loan givers, but they have underlying financial reasons. They thrive upon the interest accrued from the outstanding debts of their borrowers.
As your business continues to progress, you have to pay back these lenders. The interest rate of every loan varies according to the amount, time-line, and terms laid down by the lender.
Besides this expense, every company has to pay the taxes. These are the annual charges levied by the government.
First Step – Calculate the Cost of Debt
The cost of debt is the return that the company has to pay to its debt-holders and creditors. These financial helpers need compensation for any risks tagging along with lending to your company.
Businesses use the cost of debt to measure the overall interest they are paying on the bonds, credit cards, and loans. This rate helps you assess the debt financing. The higher it goes, the riskier your business gets in the eyes of the investors.
The simple rule to know the exact amount of the cost of debt is to find the sum of total debt and divide it by the number of loans taken.
The figure you get at the end is the loan weight. Next, you have to multiply each weight by the interest rate associated with the loan. Later, you have to add those figures to find out the Weighted Average Cost of Capital (WACC).
The purpose of WACC
The goal of WACC is to figure out the cost of a company’s capital structure. They determine this by the proportion of debt, equity, and preferred stock it has.
Every component has an associated cost. As mentioned, the company has to pay a fixed interest on its debt. Similarly, they have to pay a fixed yield on the preferred stocks and dividends in the form of cash to the equity holders.
Second Step – Calculate the After-tax Cost of Debt
A business entity needs to know how much debt costs with tax benefits plugged in. The after-tax cost of debt is the net cost of debt, determined after adjusting the gross debt cost for its tax benefits.
Many countries have tax laws, allowing deduction on account of interest expense. It causes a reduction in taxable income. Eventually, causing a decline in the income tax. This reduction is known as an income tax shield. Because of this tax benefit of interest, effective debt cost is lower than the gross debt cost.
Its formula is:
Before-tax cost of debt x (100% – incremental tax rate) = After-tax cost of debt
Why we need an after-tax cost of debt?
We have to use the after-tax cost of debt when calculating WACC. It is because we yearn to maximize the value of our stocks. The stock price depends on after-tax cash flows, not before-tax cash flows. This is why we have to adjust the interest rate downward due to debt’s preferential tax treatment.
Calculating the after-tax cost of debt gives practical insight into the business. It includes the following:
- Rate Comparisons – They can understand the value of capital and make better decisions for the future. It tells them which debts need consolidation and refinancing. It helps them to craft an effective debt policy.
- Tax Savings – It lowers the cost of capital and reduces tax liability for businesses.
- Investor Confidence – Investors wish to understand how financially healthy your business is. The after-tax cost of debt is one method to measure the overall risk factor for an organization.
Imagine your business has an outstanding loan with a 10 percent interest rate. Your company’s incremental taxes are 25 percent for federal taxes and 5 percent for state taxes. It makes a total tax rate of 30 percent.
When put into the formula, the after-tax cost of debt will be 7 percent.
In these figures, the net value of debt has reduced. It is because the 10 percent interest paid to the lender lowers the taxable income amount reported by the business.
From this example and data given above, we understand that the after-tax cost of debt can vary. It is dependent on the incremental tax value of a venture.
If they have low profitability, they will be paying taxes at a lower rate. This will cause a surge in the after-tax cost of debt. And when it’s vice versa, the tax rate goes up as profits increase. Consequently, the after-tax value of debt will decline.
In a nutshell, a business owner needs to acknowledge its after-tax cost of debt. It helps them to make smarter decisions in the future. In case you are a business owner with little know-how of numbers, you can always seek the help of professionals.
In case you don’t find someone reliable, let us know!