Why use this calculator
The rate on a loan agreement is not what the loan costs a business, because interest is normally deductible and therefore reduces the tax bill. Ignoring that overstates the cost of debt, which in turn overstates the weighted average cost of capital, which in turn causes perfectly good projects to be rejected at the discount rate stage.
This calculator applies the standard adjustment and then does the part most textbooks skip: it converts the percentage into dollars, so you can see the annual shield and the total shield across the life of the facility. It also handles the case that breaks the textbook formula, where only part of the interest is deductible.
Thin capitalisation rules, earnings-based interest caps, mixed personal and business use, and current year losses all reduce the shield below the headline tax rate, and a model that assumes full deductibility in those situations is simply wrong. Analysts, finance students and owners comparing facilities all need the same corrected number.
How to use it
- Enter the annual interest rate before tax, taken from the loan contract or, for a traded bond, the yield to maturity rather than the coupon, because yield is what the market charges today.
- Enter the tax rate that applies at the margin to the profit the deduction removes, which is your company rate or, for an unincorporated business, the marginal personal rate the income falls in.
- Set the deductible share to 100 unless a rule limits it, in which case enter the portion your tax adviser expects to be allowed after thin capitalisation or an earnings-based cap.
- Enter the drawn principal from the loan statement or the balance sheet, not the approved facility limit, because undrawn money costs a line fee rather than interest.
- Finally, enter the number of years the balance is expected to stay outstanding, taken from the facility maturity date, which is used only to total the interest and the shield.
What each result means
- After-tax cost of debt
- The percentage to use as the debt component of a weighted average cost of capital, and the rate to compare facilities on.
- Before-tax interest rate
- The contractual rate the lender charges, repeated so you can see exactly how much the deduction moves it.
- Effective deduction rate
- The tax rate multiplied by the deductible share. It is the number actually applied to the interest, and it is often lower than the headline rate.
- Annual interest before tax
- The cash interest paid to the lender each year. This is what leaves the bank account regardless of the tax outcome.
- Annual interest tax shield
- Tax you avoid because the interest reduced taxable profit. It only has value if there is profit to shelter in that year.
- Annual interest after tax
- The genuine annual cost of carrying the debt, which is the number to compare against the return the borrowed money earns.
- Interest over the full term
- Total cash interest across the years you entered, assuming the balance and the rate both stay constant.
- Tax shield over the full term
- The cumulative value of deductibility. On a long facility this is frequently larger than people expect.
- After-tax interest over the full term
- Total real cost across the term, which is the fairest basis for comparing two facilities of the same length.
The formula
After-tax cost of debt = pre-tax interest rate x (1 - effective deduction rate)
Annual interest in dollars = principal x pre-tax rate
Annual tax shield in dollars = annual interest x effective deduction rate
Annual after-tax interest = annual interest - annual tax shield
Over a term of n years the totals are simply each annual figure multiplied by n, which assumes a constant balance and a constant rate. In a weighted average cost of capital the debt component is the after-tax cost multiplied by the proportion of debt in the capital structure.
How this number is used in practice
This adjustment decides projects. A company that discounts cash flows at a weighted average cost of capital built from a pre-tax debt rate is using a hurdle that is too high, and the projects it rejects at the margin are exactly the ones that would have created value.
The effect is not small: moving the debt component from eight per cent to six per cent on a capital structure that is forty per cent debt pulls nearly a full point off the discount rate, which on a ten year project changes the present value materially.
Use the after-tax figure in the discount rate and the pre-tax figure in the cash flow forecast, never the reverse, or the deduction gets counted twice.
The shield is worth nothing if there is no profit to shield. Start-ups, companies in a loss year and businesses with large carried-forward losses get no immediate benefit from deductible interest, and the deduction is deferred rather than lost in most systems. That is why the same loan genuinely costs a profitable established company less than it costs a young one, and why the deductible share field matters: entering the statutory rate when the deduction will actually be carried forward for three years overstates the benefit today.
Tax rules also cap interest deductions in many jurisdictions once borrowing is large relative to earnings or to equity, which is what thin capitalisation and earnings-based caps do.
Rates vary by jurisdiction and by entity, which is why the tax rate is an input rather than a constant. Australian companies apply either the base rate entity rate or the full company rate depending on turnover and passive income, United States federal corporate tax sits alongside state taxes that raise the effective rate, and the United Kingdom applies a small profits rate with marginal relief before the main rate.
Personal borrowing is different again: interest on a home loan is generally not deductible in Australia or the United Kingdom, while it may be in the United States within limits, so do not apply this to a mortgage without checking. This calculator is general information for modelling, not tax advice, and the deductibility of any specific interest expense should be confirmed with a qualified tax adviser.
Worked examples
An 8 per cent facility with a 25 per cent company tax rate on 100,000 dollars
After-tax cost of 6.00% and annual after-tax interest of $6,000.00
The same loan for an Australian company on the 30 per cent rate
After-tax cost falls to 5.60%, with a tax shield of $2,400.00 a year
A 6.5 per cent loan where only 60 per cent of the interest is deductible at 21 per cent
The effective deduction rate is 12.60%, giving an after-tax cost of 5.68%
A loss-making company with no taxable profit to shelter
The shield is $0.00 and the after-tax cost stays at the contract rate of 8.00%
When people use it
- Building the debt component of a weighted average cost of capital
- Comparing two loan offers on their real cost rather than the headline rate
- Teaching or revising the cost of capital step in a corporate finance course
- Showing a board the dollar value of the interest deduction across a facility
- Stress-testing a model where only part of the interest will be deductible
Tips
- Use the marginal tax rate that applies to the profit the deduction removes, not an average effective rate from last year's accounts.
- For a traded bond, use the yield to maturity rather than the coupon. Yield is what the market charges to lend today; the coupon is history.
- If the company is in a loss year, set the deductible share low or the tax rate to zero, because a deferred deduction is worth less than an immediate one.
- Never mix a pre-tax rate into a discount rate and then also deduct the tax benefit in the cash flows. That counts the shield twice.
- Add fees separately. A one per cent establishment fee on a three year facility adds roughly a third of a point to the effective cost each year.
- Do not apply this to a personal home loan without checking deductibility in your country, because the interest is generally not deductible for an owner-occupied home.
What it assumes, and where it stops being accurate
- Assumes the interest is actually deductible in the year it is incurred and that there is enough taxable profit to absorb it. Where a deduction is carried forward, its present value is lower than shown.
- Assumes a constant principal and a constant rate across the term. An amortising loan pays interest on a falling balance, so the totals here overstate a repayment loan.
- Ignores establishment fees, line fees, break costs, arrangement costs and any capitalised borrowing expenses, all of which raise the real cost of a facility.
- Ignores the deadweight cost of financial distress and covenant restrictions, so it should not be read as an argument that more debt is always cheaper.
- Not accurate for hybrid instruments, convertible notes, related party debt or leases, where deductibility and classification follow special rules.
- Not tax advice. Thin capitalisation, earnings-based interest caps, transfer pricing and personal deductibility all require professional confirmation for your own situation.
Terms used on this page
- Cost of debt
- The rate a business pays to borrow, expressed annually, either before or after the effect of tax deductibility.
- Interest tax shield
- The reduction in tax caused by deducting interest, equal to the interest paid multiplied by the effective tax rate.
- Weighted average cost of capital
- The blended required return across debt and equity, weighted by each source's share of the capital structure.
- Thin capitalisation
- Tax rules that restrict interest deductions when a company is funded with more debt than the rules permit.
- Yield to maturity
- The annual return implied by a bond's current price and its remaining cash flows, used as the market cost of that debt.
Questions people ask
- Why multiply by one minus the tax rate?
- Because deductible interest reduces taxable profit, so for every dollar of interest paid the tax bill falls by the tax rate times that dollar. The government effectively contributes that share of the interest, and multiplying by one minus the rate converts the contractual cost into the cost the borrower genuinely bears.
- Is after-tax cost of debt the same as the annual percentage rate?
- No. An annual percentage rate describes the contractual cost of borrowing including certain fees, and it takes no account of tax. After-tax cost of debt adjusts a rate for the deductibility of interest, so it is a modelling figure for a business rather than a disclosure figure for a consumer.
- What tax rate should an Australian business use?
- A company will generally use either the base rate entity rate or the full company rate depending on its turnover and the share of its income that is passive. A sole trader should use the marginal personal rate that the sheltered income would have fallen into, and only for interest that is genuinely incurred in earning business income.
- Does this work when the company is making a loss?
- Not directly. If there is no taxable profit, the deduction cannot be used this year and is usually carried forward instead. Set the tax rate to zero or reduce the deductible share to reflect that, because a deduction available in three years is worth considerably less than one available now.
- How does this fit into a weighted average cost of capital?
- The debt component of a weighted average cost of capital is the after-tax cost of debt multiplied by the proportion of debt in the capital structure. It is added to the cost of equity multiplied by the proportion of equity. Using the pre-tax rate here is the most common error in student and pitch deck models.
- Why is there a deductible share field?
- Because full deductibility is an assumption, not a fact. Thin capitalisation rules, earnings-based interest caps, mixed personal and business use of a borrowed asset, and related party lending rules all limit how much interest can be deducted, and the shield should be scaled accordingly rather than assumed.
Use this with
After-Tax Cost of Debt Calculator answers one part of the question. These pick up where it stops: Business Loan Calculator, NPV and IRR Calculator, ROI Calculator and APR to APY Converter.
Where these figures come from
This calculation is jurisdiction-neutral arithmetic. No country-specific rules are applied.
- Australian Taxation Office. Deductibility of interest, company tax rates and thin capitalisation rules
- Internal Revenue Service, businesses. United States business interest expense limitation and corporate tax treatment
- CFA Institute. Standard treatment of the cost of debt within the weighted average cost of capital
After-Tax Cost of Debt Calculator produces an estimate for general information. It is not financial, tax, medical, legal or engineering advice. read the full disclaimer. Spotted a wrong number? Report it and it gets fixed. The form picks up this calculator and the inputs you used.