How a decline in tax rates impacts the aftertax cost of debt?
This page answers the question of how a decrease in tax rates impacts the aftertax 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 aftertax cost of debt by multiplying the cost of debt by “1 minus the taxrate”. 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 aftertax 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 aftertax 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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