Cost of Debt

[acdelatorre]

Hello,

I was referred to join here by Mr. Joe Styles from Investopedia.com. There is this one question that has been bugging me for about a month now.

WACC is calculated as:

[(E/V) * Re] + [(D/V) * Rd * (1-Rt)]

Where;

E = Total Equity

D = Total Debt

V = E + D

Re = Cost of Equity

Rd = Cost of debt

Rt = Tax rate

Now, my question is - why is there such a concept as a pre-tax cost of debt and post-tax cost of debt? Why is the cost of debt being multiplied by (1-Rt)? I have begun my foray into the world of management accounting by first studying cash flows, so I can't see the implications of these concepts. I mean...why not be the 'cost of debt' be just it and not multiply it anymore by the said factor? Please help me.

Many thanks,

lex

[Cash Flow King]

Hmm, a cash flow question...
I suppose I should give it a shot since I am the "Cash Flow King."

The interest the company pays on its debt is deductable and Rd itself does not include the tax deduction benefits the company receives. Thus, you must subtract the amount in which the company saved (from the deduction) from the paid interest. The pre-tax cost of debt (Rd) does not include the deduction benefits, therefore, the post-tax cost of debt is a better figure to use.

Ex.
A company issues a bond and it pays 4% on it. The pre-tax cost of debt would just be 4%. But if the company's Rt were 25%, the post-tax cost of debt would be calculated as 0.04*(1-0.25)*100 = 3%. This is the general concept behind the pre- and post-tax cost of debt.

[WallStGolfer31]

Originally Posted by acdelatorre

Hello,

I was referred to join here by Mr. Joe Styles from Investopedia.com. There is this one question that has been bugging me for about a month now.

WACC is calculated as:

[(E/V) * Re] + [(D/V) * Rd * (1-Rt)]

Where;

E = Total Equity

D = Total Debt

V = E + D

Re = Cost of Equity

Rd = Cost of debt

Rt = Tax rate

Now, my question is - why is there such a concept as a pre-tax cost of debt and post-tax cost of debt? Why is the cost of debt being multiplied by (1-Rt)? I have begun my foray into the world of management accounting by first studying cash flows, so I can't see the implications of these concepts. I mean...why not be the 'cost of debt' be just it and not multiply it anymore by the said factor? Please help me.

Many thanks,

lex

You have two different cots of debt, post taxes and pre taxes, becasue often times you can get a tax break on interest paid during certian circumstances. I can't recall exactly how though, I left my book back home on the subject, but If i had it here I could tell you exactly why! lol

[acdelatorre]

Thanks, Cash Flow King and WallStGolfer31...

[gijoe9]

Could not sleep so was surfing and found this site. http://www.quickmba.com/ Seems like it has everything you need to get an mba there it may help you to better understand but it is not my area of expertise sry. There is a term search option there which I found helpful.
Hope this helps,
Joe

[Stocktrading101]

BuMp,