Overview: Cost of Debt, Taxation, & Capital Structure

The cost of debt is the interest rate a company pays on its debt, and it is influenced by taxation and the company’s capital structure.

Cost of Debt

The cost of debt includes interest payments and other borrowing costs such as fees and penalties. It is a crucial factor in a company’s financial health and capital structure. A company’s cost of debt can be calculated using the formula:

A company with a high cost of debt may face lower credit ratings, increased financial risk, or unfavorable market conditions.

Taxation

The tax rate a company pays affects its cost of debt, which in turn influences the company’s capital structure. Since interest expenses are tax-deductible, the cost of debt is calculated on an after-tax basis.

The formula for the after-tax cost of debt is:

Cost of debt= (Total interest expenses /Total debt) x (1-Tax rate)

Example Calculation:

A company has the following debt structure:

• Loan: Rs. 10 million at an interest rate of 7%
• Bonds: Rs. 2 million at an interest rate of 6%
• Tax rate: 30%

Solution:

Total borrowing: 12000000

Average rate of interest payable is 700000+120000=820000/12000000= 0.068 or 6.8 percent

6.8% × (1-30%)= 6.8 × 0.70 = 4.76 %

Thus, the effective after-tax cost of debt is 4.76%.

Tax considerations play a significant role in determining a company’s capital structure and cost of capital.

Capital Structure

A company’s capital structure is the mix of debt and equity it uses to finance its operations and assets. Tax considerations significantly influence capital structure decisions, as companies aim to optimize their financing mix to minimize costs and maximize value.

The trade-off theory suggests that a firm’s capital structure is determined by balancing the benefits of debt (such as tax advantages) against its costs (such as financial distress). Lower tax rates reduce the incentive to hold debt by decreasing interest tax-deductibility benefits.

The cost of debt impacts capital structure choices, as lower interest rates allow firms to take on more debt. Additionally, companies can leverage debt to reduce their tax liabilities due to the tax advantages it offers over equity.

The tax benefit of debt allows companies to reduce their weighted average cost of capital (WACC) and increase firm value by substituting debt for equity, provided that interest payments remain tax-deductible.

Rather than directly influencing the total debt in a firm’s capital structure, taxes affect the relative composition of debt. Firms often shift from private intermediated debt to public bond debt in response to changes in marginal tax rates. Firms’ debt policies tend to be most sensitive to tax rates in high-interest-rate environments.