I don’t completely grasp why the cost of debt reduces after taxes. For instance, I don’t understand how if the company borrows $1000 from its debtors, and the tax rate is 30% , why the % cost of financing the debt would reduce after taxes.
Can someone shed light on this, perhaps with an example?
In many places (such as the US), the government loves you so much that they subsidize your cost of borrowing: you get to deduct your interest payments from your taxable income, so your taxes are lower.
If you borrow $1,000 at 6% interest, your interest expense is $60. Because you get to deduct that $60 from your taxable income, you save $18 (= 30% × $60) in income taxes. So your net payment for interest is $60 − $18 = $42; your effective interest rate is 4.2% (= 6% × (1 − 30%)).
Got it, this was really helpful as I didn’t know that. Thanks!
My pleasure.
How do you find the cost of debt on a balance sheet?
The material spends too much time on formulas, rather than communicating how to soruce the information needed to input in the formula.
Half the formulas are only as good as the information you can source.
Generally, you don’t.
You have to look at the price at which the debt is trading in the market.
I guess unless you know the maturity date of the debt, you can’t figure out the cost of debt …Is the only way to figure it out via form 424b2s (US filing bond offerings)?
Is it safe to assume, pretty much all company debt is in the form of corporate bonds and/or convertable bonds, and its not borrowed and owed to a bank or other institution. And the proxy for the rate on company debt is the yield on on offer on corporate bonds - a benckmark index or average for the market rate for AAA corporate bonds all the way down to lower graded bonds.
Although what if the company is not doing that great, and its debtors ask for a higher yield - does a lower bond rating show on the balance sheet, or a preivous announcement that should be public informaiton.