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Mastering Discounted Cash Flow Analysis with Excel
Mastering Discounted Cash Flow Analysis with Excel
How to Calculate Cost of Debt
Debt is one of the primary ways companies finance their operationsβthrough 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:
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:
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.
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