Interest is deductible, so a company borrowing at 6.5% with a 21% tax rate is not paying 6.5%. It is paying 5.135%, because the tax deduction returns 21% of the interest. That adjustment is small enough to be forgotten and large enough to change which financing looks cheaper.
Someone building a cost of capital or WACC figure has a pre-tax borrowing rate and a tax rate, and needs the after-tax figure that goes into the weighted average rather than the rate on the loan document.
Interest is a cost of doing business, and like other costs it comes out of profit before tax is calculated. So every dollar of interest a company pays reduces its taxable profit by a dollar, and the tax it would have paid on that dollar stays with the company.
At a 21% tax rate, $1,000,000 of debt at 6.5% costs $65,000 in interest. That $65,000 comes off taxable profit, so the tax bill falls by 21% of it — $13,650. The net cost is $51,350, which is 5.135% of the million rather than 6.5%.
The pattern is exact and worth internalising: the tax rate is the share of the interest that comes back, whatever the interest rate is. At 35% tax, an 8% loan costs 5.2%; at 21%, a 5% loan costs 3.95%. The reduction is always the pre-tax rate times the tax rate, so a higher tax rate compresses every borrowing rate by the same proportion.
The after-tax cost of debt is the input to a weighted average cost of capital. A company funded 40% by debt at 5.135% after tax and 60% by equity at, say, 11% has a WACC of about 8.65%. Using the pre-tax 6.5% instead gives 8.72% — a difference of seven basis points, which sounds negligible until it is applied to every project the company evaluates for a decade.
The mistake is easy because the pre-tax rate is the one that appears on the loan document, and the tax rate lives somewhere else entirely — a different system, a different team, a different reporting period. Nothing on the loan statement says the cost is lower than the rate.
The same adjustment applies to a household only sometimes. Mortgage interest is deductible if you itemise and the loan is within the limits, which means a homeowner in the 24% bracket with a 6.5% mortgage has an effective cost of about 4.94% — but only on the part of the interest that exceeds the standard deduction. For most households in the United States since 2018 the standard deduction is large enough that no mortgage interest is deducted at all, and then the effective cost is the full rate. A company almost always gets the shield; a household often does not.
It assumes the interest is deductible for this borrower. Some debt is not: interest on debt used to buy tax-exempt bonds is disallowed, and several jurisdictions limit the deduction once interest exceeds a share of earnings. Where a limit applies, the effective shield is smaller than the tax rate suggests and the after-tax rate sits somewhere between the two figures.
It assumes there is taxable profit to deduct it against. A company running at a loss does not get a cheque for the shield — the deduction carries forward to a year with profit, and a deduction in three years is worth less than one today. For a loss-making company the honest cost of debt is the full pre-tax rate, and this calculator will overstate the benefit.
Neither condition is visible in the inputs. That is the reason the formula is worth stating plainly and its assumptions worth stating next to it: a single multiplication is easy to trust and it is doing more work than it looks like.
after-tax cost = pre-tax rate × (1 − tax rate)
The formula is a single multiplication, and it holds exactly: the reduction is always the pre-tax rate times the tax rate, so a 21% tax rate removes 21% of the cost whatever the rate is. That proportionality is worth noticing, because it means the after-tax figure is not a different ranking of financing options — it is the same ranking compressed. The two conditions underneath it are what the page is really about.
The interest is $65,000 a year. At a 21% marginal rate the deduction is worth $13,650, so the net cost is $51,350 — an after-tax rate of 5.135%, which is 1.365 percentage points below the quoted 6.5%. The reduction is exactly 21% of the pre-tax rate, because the tax rate is the share of the interest that comes back.
Set the tax rate to zero and the after-tax rate comes back as 6.5% — unchanged — with a shield of $0 and a net cost equal to the full $65,000 of interest. This is not a degenerate case; it is the correct answer for a company with no taxable profit, and it is the number a loss-making company should be using in its cost of capital rather than the reduced figure. The deduction is only worth something when there is profit for it to reduce.
An 8% facility with a 35% marginal rate: $500,000 of debt costs $40,000 in interest, of which $14,000 comes back, leaving $26,000. The after-tax rate is 5.2%. Note that the reduction is 2.8 percentage points — larger than Example 1 in absolute terms, even though the pre-tax rate is only 1.5 points higher. A higher tax rate amplifies the shield on every rate, which is why the same loan costs differently in two jurisdictions.
The interest rate a borrower actually bears once the tax deduction on interest is counted. It is the pre-tax rate multiplied by one minus the tax rate. A 6.5% loan with a 21% marginal tax rate costs 5.135% after tax, because 21% of the interest comes back as a smaller tax bill.
Because interest is a contractual cost of doing business and dividends are a distribution of profit after tax. The tax system treats them differently on purpose, and the difference is a real subsidy to debt financing — which is why the after-tax cost of debt sits below the cost of equity in almost every capital structure.
Only if you itemise your deductions and the interest exceeds the standard deduction, and only within the loan limits. In the United States the standard deduction is large enough that many homeowners deduct no mortgage interest at all, and for them the effective cost is the full rate. A company almost always gets the deduction; a household often does not.
The marginal rate — the rate that applies to the next dollar of profit — rather than the average rate on the last set of accounts. The deduction offsets profit at the margin, so the marginal rate is what it is worth. The two differ whenever a company crosses a bracket or has credits and adjustments.
Yes, and it is the only input in WACC that gets a tax adjustment. The cost of equity is already an after-tax figure, because shareholders are paid from profit after tax. Applying the tax shield to equity as well is a common error and it understates the weighted average.