Although you are getting tax savings of 30% of 10%, you are still paying 10% as cost of debt. If you didn't take that debt you had to pay 30% of 10% as tax because payment to equity holders are not tax deductible meaning than you can not subtract cost of equity from net income to calculate tax. but you could deduct cost of debt from net income to calculate tax.

as you are giving 10% as cost of debt, the debt provider is also getting 10% as return on investment. you and debt provider jointly avoid the tax. Debt provider will pay their own tax depending their own revenue.

Good question. The tax saving to the company borrowing debt is only notional!

I agree with the view of Dr. Md

if we are 10% as cost of debt, what does after tax cost debt indicate from debt capital contributors point of view.

morever, though, interest is exempted in the hands of the company, it is taxable in the hands of debt capital contributors.

it means, 7% cost of debt(i..e, after tax cost debt) is only from the company view point, but not from the debt capital contributors view point. am I right?

After tax cost is equal to (cost)×(1-t)

Where t=tax rate

The after-tax cost of debt is the interest rate on the debt multiplied by (100% minus the incremental  income tax rate). For instance, if the cost of debt is 20% and the incremental income tax rate is 30%, after tax cost of debt will be 20% x (100%-30%) = 14%.

I think it is true to think that 10% interest expense saves us paying taxes 0.10X0.30 = 0.03, 3% tax saving makes the interest cost 7% for the borrower. For the debt provider the revenue is still 10% on the amount of loan lent. 7% of after tax interest expense is an attraction for the borrower, however, the borrower should be aware of the leverage. If the borrower`s ROA rate is higher than 7% it is OK to borrow at 7%, if it is not then paying 7% interest will still reduce its ROA rate. Another issue is the Debt/Equity ratio, borrowing is not limitless, more borrowing might deteriorate debt/equity ratio and you might lose the 7% advantage and forced to borrow from higher rates (because of you company`s increased risk).

The question at hand has to be evaluated from both financial accounting (statutory annual accounts) and financial management.

Under financial financial accounting, a firm can adopt IAS 23 Borrowing Costs to capitalize interest expenses and associated costs such as fees and charges. If this is adopted, the issues regarding after tax cost of debt would not rise. If firm opts to expense the cost of debt, the matter would depend on the volume of debt in relation to PBIT (Profit Before Interest and Tax) or EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). If already too low, the issues of benefiting from interest expenses deductions will not matter much. More firms would rather seek capitalization of borrowing costs if possible.

Under financial management, the best way of calculating cost of debt would be use Weight Average Cost of Capital which also factors in cost of equity financing and cost of debt (which includes after tax cost of debt). In a nutshell, equity financing should also be considered when a firm is seeking appropriate debt capital.

I do not quite agree with the above answers because they have attempted to answer a question that is a little ambiguous in the following respects:

"cost of debt is 10% and tax rate is 30%. then, after tax cost of debt will be 7%" Yes that is the cost of the debt liability to the borrower. But it is not the cost of debt to the lender because from the lender's perspective it is an asset not a liability. The lender will have borrowed those funds from other sources (eg customer deposits in the case of a bank, or maybe wholesale borrowing from other banks) so the lender will have a completely different and unrelated cost of debt. The lender's marginal tax rate may also be different from that of the borrower.

"so, how can the after tax cost of debt(i.e., after tax required rate of return) be 7%?" Because that is the after-tax cost of debt to the borrower not the lender, as explained above.

"it means, 7% cost of debt(i..e, after tax cost debt) is only from the company view point, but not from the debt capital contributors view point. am I right?" Yes. But in your question you have used the terms "firm", "company", "debt capital providers", "contributors of capital", "contributors of debt capital", "debt capital holders" ... which makes your question difficult to follow.

I am fairly sure you are only ever referring to Borrower and Lender. So if you only used those two terms the question would probably be clearer to understand.

Hope that helps!

thank you very much prof. Chris Kelly for your valuable answer for your querry.

i have got one more doubt based on your answer.

does the cost of equity also refer to the same meaning?(ie., from company view point, but not from shareholders view point)

but, many standard text books on financial management mention that cost of capital is the minimum required rate of return of the contributors of the capital?

do you say that those defitions are flawed?

thanks in advance

While the cost of debt can be calculated from the loan agreement(s), the cost of equity, being the return demanded by shareholders, is not contractual but inferential.

Estimating the cost of equity gets us into the incremental risk of investing in a company versus a risk-free investment such as government bonds (which may not actually be risk-free in the event of default). CAPM attempts to solve this, but its inputs for beta and market returns are, in my view, subjective.

I do not like how CAPM estimates a company's beta from historic price volatility as that does not seem a reliable way of estimating future risk which can be subject to a huge array of factors other than price volatility. But nor can I offer a better alternative!

Some brief comments in addition to the answers provided above:

1. Cost of debt after tax from the borrower's perspective are 7%. Taxes payable by the lender on the interest received are his (the lender's) problem. Or: imagine the debt investors (lenders) to be private investors whose income is not subject to the corporate tax rate.

2. Cost of equity are indeed to be derived from the equity investors (owners) point of view. But this is not a questionable observation, but the result of the overall objective of the firm to maximize the value of equity, i.e. maximize the value for the owners. Cost of debt after tax are the cost for a source of external finance (from the borrowing company's perspective and the perspective of its owners) and are to be considered as one variable for achieving this objective.

Best

Andreas

The lender defines his expected return and fixes the interest rate. He does not actually bother about the cost of debt whether pre-tax or post-tax to the borrower.