The cost of capital is the weighted-average, after-tax cost of a corporation’s long-term debt, preferred stock (if any), and the stockholders’ equity associated with common stock. It is also considered to be the minimum after-tax internal rate of return to be earned on new investments.

The reason behind this is that the interest is a tax-deductible expense. It means that the taxable income of a company is calculated after deducting the interest expense. Hence, interest results in tax-saving and it reduces the cost of debt by the amount of tax reduced.

Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to lenders since payment on a debt is required by law regardless of a company’s profit margins.

The cost of debt is simply the amount of interest a company pays on its borrowings or the debt held by debt holders of a company. Cost of equity is the required rate of return by equity shareholders, or we can say the equities held by shareholders.

The after-tax cost of debt is the interest paid on debt less any income tax savings due to deductible interest expenses. To calculate the after-tax cost of debt, subtract a company’s effective tax rate from 1, and multiply the difference by its cost of debt. The after-tax cost of debt is 3.5%.

The WACC is a calculation of the ‘after-tax’ cost of capital where the tax treatment for each capital component is different. In most countries, the cost of debt is tax deductible while the cost of equity isn’t, for hybrids this depends on each case.

The after-tax cost of debt is the interest paid on debt less any income tax savings due to deductible interest expenses. The after-tax cost of debt is 3.5%. The rationale behind this calculation is based on the tax savings that the company receives from claiming its interest as a business expense.

The after-tax cost of debt is more relevant because it is the actual cost of debt to the company. The pretax cost of debt is equal to the after-tax cost of debt, so it makes no difference.

All else being equal, the higher the debt-to-capital ratio, the riskier the company. This is because a higher ratio, the more the company is funded by debt than equity, which means a higher liability to repay the debt and a greater risk of forfeiture on the loan if the debt cannot be paid timely.

The primary benefit of calculating the after-tax cost of debt is knowing how much a business can save on its taxes due to the interest it paid over the year. This means businesses need to know their effective tax rate to understand their total cost of debt. Calculating the effective tax rate for a business is easy.

WACC is the average after-tax cost of a company’s various capital sources, including common stock, preferred stock, bonds, and any other long-term debt.

Equity capital reflects ownership while debt capital reflects an obligation. Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to lenders since payment on a debt is required by law regardless of a company’s profit margins.

Subtract the company’s corporate tax rate from 1. For example, subtract 35 percent, or 0.35, from 1, which equals 0.65. Multiply your result by the rate the company would need to pay if it issued new debt to determine the company’s after-tax cost of new debt. For example, multiply 0.65 by 5 percent, or 0.05, which equals 0.033.

Tax savings can be made on debt while equity is tax payable. Interest rates payable on debt is generally lower compared to the returns expected by equity shareholders. WACC calculates an average cost of capital considering the weightages of both equity and debt components.

The cost of debt is simply the interest expense that the lender will charge on the loan. The post-tax cost of debt is 3%, which is calculated as 5% * (1 – 40%) = 3%.