- #1
Square1
- 143
- 1
Hi,
There is a cost of debt formula that goes c = ib(1-T), where c is the cost of issuing debt that firm incurs ( a percentage like interest) i is the interest earned by the investor, and T is the tax rate a firm pays. The key is that the interest rate alone is not really the cost of taking on debt. Although the investor will obtain the interest rate i from the company, the effective rate being paid by the company is less than i. This is because at the end of financial period, a firm can always deduct interest payments on debt from taxable income.
I understand the logic that the effective cost of debt to the firm will be less than some nominal interest rate, but I don't understand the the mechanics of this formula. Can someone help? One thing that is confusing me is that the interest rate would get applied to one quantity, whereas the tax rate would be applied to another quantity. How can we establish a relationship between the two based on that while not referencing these quantities in the formula?
Thanks
There is a cost of debt formula that goes c = ib(1-T), where c is the cost of issuing debt that firm incurs ( a percentage like interest) i is the interest earned by the investor, and T is the tax rate a firm pays. The key is that the interest rate alone is not really the cost of taking on debt. Although the investor will obtain the interest rate i from the company, the effective rate being paid by the company is less than i. This is because at the end of financial period, a firm can always deduct interest payments on debt from taxable income.
I understand the logic that the effective cost of debt to the firm will be less than some nominal interest rate, but I don't understand the the mechanics of this formula. Can someone help? One thing that is confusing me is that the interest rate would get applied to one quantity, whereas the tax rate would be applied to another quantity. How can we establish a relationship between the two based on that while not referencing these quantities in the formula?
Thanks