How this calculator works
Interest on business debt is normally deductible, so the true cost of borrowing is the pre-tax rate reduced by the tax saved on the interest. The marginal tax rate is the rate applied to the next dollar of taxable income, which is usually the right rate for a financing decision. A lender quotes the pre-tax rate; this page converts between the two, or recovers the tax rate the figures imply. The tax shield output shows the cash saved on $1,000 of debt interest, which is the interest times the tax rate. The model assumes the interest is fully deductible and ignores deferred taxes, credits and any limit on the deduction.
Formula
After-tax cost of debt = r x (1 - t). Rearranged, r = after-tax cost / (1 - t) and t = 1 - after-tax cost / r. From financial statements the effective rate is t = (pre-tax income - net income) / pre-tax income. The annual tax shield on a debt balance is balance x r x t.
Worked example
A company borrows at 6.5% and pays a 26.5% marginal tax rate. The after-tax cost of debt is 6.5% x (1 - 0.265) = 4.7775%, displayed as 4.7775%. Each $1,000 of interest therefore costs $735 after tax, a shield of $265. Working backwards, an after-tax cost of 4.78% at a 26.5% rate implies a pre-tax rate of 4.78% / 0.735 = 6.5034%.
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Frequently asked questions
Should I use the marginal or the average tax rate?
Use the marginal rate for a decision about new borrowing, because the next dollar of interest is deducted at that rate. The average rate includes prior years, credits and non-deductible items and can understate the shield.
Is the after-tax cost of debt the same as the interest rate?
Only when the tax rate is zero. Otherwise the after-tax cost is lower. It is the rate that belongs in a weighted average cost of capital, alongside an after-tax cost of equity.
What if the company is not profitable?
A loss-making company may not use the interest deduction in the same year, so the immediate shield can be smaller or deferred. The formula still shows the long-run shield if the deduction can be carried forward.
Do fees change the answer?
Yes. Issuance costs and origination fees raise the effective pre-tax borrowing cost. Either add them to the rate or amortise them over the loan before applying the tax adjustment.