Debt is one of the primary ways companies finance their operations—through bank loans, bonds, lines of credit, or leases. Each of these comes with a price tag: interest. This interest is what we refer to as the cost of debt.

But there's a twist: interest is usually tax-deductible.

In most tax systems, interest payments reduce a company's taxable income. This creates a tax shield, meaning the true cost of debt is less than the nominal interest rate.

That's why we use the after-tax cost of debt in valuation.

Here's how it's calculated:

$\text{After-Tax Cost of Debt} = \text{Interest Rate} \times (1 - \text{Tax Rate})$

This reflects the net cost to the company after considering tax savings. For example, if a firm pays 6% interest and faces a 25% tax rate:

$\text{Cost of Debt} = 6\% \times (1 - 0.25) = 4.5\%$

You might determine the interest rate from:

• The company's actual loan agreements;
• The yield to maturity on corporate bonds;
• An average of current market rates for similar firms.

The after-tax cost of debt is a crucial component in valuation and capital structure analysis. It rewards firms that finance strategically and leverage the tax system to reduce capital costs.