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The after-tax cost of debt is the interest rate on the debt multiplied by (100% minus the incremental income tax rate).For instance, if a corporation's debt has an annual interest rate of10% and the corporation's combined federal and state income tax rate is30%, the after-tax cost of debt is7%. The computation is: [10% interest rate X (100% minus30% tax rate)] = [10% X70%] =7%.Here is the example in dollars. If the corporation has a loan of $100,000 with an annual interest rate of10%, the interest paid to the lender will be $10,000 per year. This interest expense will reduce the corporation's taxable income by $10,000 thereby saving the corporation $3,000 in income taxes (30% tax rate on $10,000 reduction in taxable income). The after-tax cost of the debt is computed as follows: $10,000 paid to the lender minus $3,000 of income tax savings equals a net cost of $7,000 per year on the $100,000 loan. This means the after-tax cost is7% ($7,000 divided by $100,000).
After-Tax Cost of Debt = Before Tax Cost of Debt × (1 – Tax Rate)
