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How a decline in tax rates impacts the after-tax cost of debt?

This page answers the question of how a decrease in tax rates impacts the after-tax cost of debt and the overall weighted average cost of capital for a company. As an example, let’s say that a company has a loan with an interest rate of 5%, which is their cost of debt. We can also say that the current tax rate is 30%, but tax rates are expected to decline to 25%.

We can calculate the after-tax cost of debt by multiplying the cost of debt by “1 minus the tax-rate”. We do this because interest expense is tax deductible, so we need to take into account the decrease in taxable income from interest payments a company makes on their debt.

So looking at our example below, we can see that when the tax rates decrease, this increases the after-tax cost of debt. This really just means that the benefit received from interest payments being tax deductible is less impactful on a lower tax rate.

If the after-tax cost of debt increases, then the overall weighted average cost of capital will increase as well. The overall impact to a company really depends on the ratio of debt in their capital structure. If debt is a small piece of the capital structure, the impact to the weighted average cost of capital will be minimal.

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