Hi Guys, In WACC, interest paid on debt is the cost of debt. Now this interest is tax deductible and hence gives the tax shield to the company. However, why do we consider after-tax cost of debt -the cost of debt is the interest paid and despite getting the tax shield from the govt, the company had still paid the actual interest cost (whatever the interest rate was) and hence its cost of debt is not reduced. The tax saving that the company gets is basically improving its bottomline but its not affecting the interest cost that the firm is paying. $1M interest cost against $10M debt at 10%. Tax rate 40%. Tax shield =$0.4M, but the company still paid $1M in interest to the bank. Any thoughts ? thanks
If you paid $100 for a phone with a $50 immediate rebate, how much did you net pay? $50, or $100? If you but a $50 phone with a 100% tax, did you pay $100 or $50?
To understand this question…I think it’s best to look at an Income Statement EBIT I EBT TAXES NI Interest (from debt) is removed before the calcuation for taxes…hence the firm effectively only pays the after-tax amount of interest.
$1m should be treated as the Coupon Amount. $1m the Cash Outflow which has nothing to do with the income tax rate of the firm. However the Interest Expense which is recorded in the income sheet, is affected by the income tax expenses. Cost of debt is calculated with values from income sheet where the interest expense is reduced by income taxes.
CFA_2012 Wrote: ------------------------------------------------------- > $1m should be treated as the Coupon Amount. > > $1m the Cash Outflow which has nothing to do with > the income tax rate of the firm. > > However the Interest Expense which is recorded in > the income sheet, is affected by the income tax > expenses. > > Cost of debt is calculated with values from income > sheet where the interest expense is reduced by > income taxes. How does the interest payment having nothing to do with taxes? You’re last two paragraphs perfectly explains what I wrote, as well as contradicting your first comment… Interest on debt is tax deductable…how else would a firm save on taxes if it’s not through the income statement? Come on…Look back to the original question "after-tax cost of debt in WACC) Look back at the income statement, and interest expense is deducted before tax is calculated…hence the “debt tax shield” Think about the reason why Kcs (cost of common equity) is not reduced by after tax amount in WACC…the dividends paid to common shareholders is taken from Net Income, which is already after-tax! Hopefully this helps…I’m not accounting expert at all and my comments may not be that well written, but I think this is a fairly obvious explanation…
But simply put : cost of debt: is what is paid to the suppliers to obtain those funds which is essentially the interest component. So reducing the interest by tax (as mentioned by MFIN in his/her example) although makes sense -but why is it being treated as the actual cost when in effect the company did end up paying $1M and not $1M-$400K=$600K. I cant quite digest this fact. The tax relief that it got was a tax credit provided by the govt and should be seen as basically the company paying less in tax (not less in interest and hence the cost of debt)
I understand your curiosity…no worries! Well, I think it has to do with the EFFECTIVE cost…there’s no reason why a company should be valued (valuation through FCFF uses WACC to discount the cash flows), or NPV analysis (which the cash flows are discounted by WACC), without looking at the EFFECTIVE cost… The company does pay $1 million dollars in interest (coupon) payments, yes, BUT it effectively only costs them $1 million (1-tc) because of the savings they receive from the tax shield provided by the government… Look into Optimal Capital Structure literature by Modigliani & Miller…Without the financial distress (possiblity of default), the company will maximize it’s value by using 100% debt because of the Debt Tax Shield (tax savings from debt)…but when you add the realistic issue of debt increasing the financial distress, you need to raise equity… Overall, debt is the cheaper method of raising cash by a firm because of the tax savings BUT up to a certain point…the optimal cap. structure, well obviously hard to gauge… I hope this helps, I’ve taken many courses on corporate finance and at high levels…I hope I retained SOME of it… haha…please let me know if you still have any issues…
-------------------------------------- MFIN— Wrote: > How does the interest payment having nothing to do > with taxes? You’re last two paragraphs perfectly > explains what I wrote, as well as contradicting > your first comment… ------------------------------------------------------------------- The company has to make a payment of $1M to the bank. This Cash outflow will always remain $1M irrespective of whether the tax rate is 40% or 50%. -------------------------------------- MFIN— Wrote: > Interest on debt is tax deductable…how else > would a firm save on taxes if it’s not through the > income statement? Come on…Look back to the > original question "after-tax cost of debt in > WACC) --------------------------------------------- Now the amount of $1M that the company paid to the bank, will be tax-deducted in the income statement of the firm. If the tax rate is 40%, the firm will save 400K in taxes and if the tax rate is 50%, it will save 500K in taxes. But it still has to pay $1M in cash to the bank. That is why I said, the payment to the bank and saving from taxes are two different calculations.
yes…what exactly are you trying to argue here… Obviously a million dollar payment is a million dollar payment…but you need to look at after-tax calculations which is what the firm really cares about, and hence used in it’s calculation to find the discount rate… Anyway, I think I’ve contributed enough to this forum…I am100% confident with my answers; however if anyone disagrees, feel free to debate amongst yourselves… This topic is the most introductory basic finance material you can get…just move on
MFIN: Your answers are 100% correct. No doubts. Both of us are saying the same thing but with different perception. And I am not arguing with you. I am a member of this forum to help others and to learn from others. (TEAM: Together Everyone Achieves More) so chill bro. I just said the same concept in a different style as the original poster had asked why the cost of debt is $600K and not $1M. I am trying to clarify to OP that even though the interest paid is $1M, its value of cost of debt on income tax is $600K (which is what you said “hence the firm effectively only pays the after-tax amount of interest.”) after 40% savings on tax.
Okay, sounds good…no worries over here man…I enjoy AF…great help and lots of intelligent people…sorry if I came off rude, it wasn’t my intention Good luck with your studies! I’ve got to stop using this forum, but I’m addicted… haha
Thanks guys and thanks MFIN : i think you were dot point in removing my doubts. i CAN digest the fact now haha…i guess i would have to keep in mind that ‘effective’ cost to the firm is after it accounts for the tax shield/contribution. The word effective is the key. i.e. it is reducing the firm’s cost as govt contributes or provides for part payment of the cost and hence the benefit…the book you mentioned and the concept you mentioned was very useful. Thanks a bunch for sharing your intellect !! =)
There is a very simple explanation for your question which will clarify your thinking process: Assume a company has $1mm in EBIT, is debt-free and has a tax rate of 40%, the company will have to pay $400K in taxes. Now if the company has $1mm in interest to pay due to debt it has, then yes, the company will have to pay $1mm in interest, but it is only $600k greater than the $400k in taxes it has to pay anyways. Therefore the real cost of debt is really just the incremental $600k. Simple?
Excellent read! 
I don’t quite get this. If the company has $1m to pay in interest, its EBIT is still $1m but its earnings after interest are now 0 and it doesn’t have to pay any tax.
Exactly. So 1 mill interest, but 0 taxes vs 0 interest, but 400k taxes. Difference of 600K is the incremental cost of debt, the only relevant part.
Without the interest expense it would have paid $400,000 in taxes; with the interest expense it pays $0 in taxes. Its tax expense has decreased by $400,000, which is tantamount to $400,000 in additional after-tax income. The net effect of paying $1,000,000 in interest is a cash outflow of $600,000 (= $1,000,000 − $400,000).