Question

Why do we use an after-tax figure for cost of debt but not for cost of equity?

Answer 1

Answer

• By the term ‘cost of debt’ we mean the ‘interest part’ that the company has to pay to the lenders and by the term ‘cost of equity’ we mean the dividends that the company has to pay to the shareholders.
• Now, the ‘Interest part’ that the company pays on the borrowed debt is a ‘tax-deductable expense’ to the company which means that the company can charge such expense to its profit & loss account which will ultimately reduce its taxable income and therefore it will get a ‘tax saving’ on such amount.

Hence, the net cost to the company is :

net cost = interest cost (-) tax saving on such interest

ie. After-tax Cost

• On the other hand, the ‘Dividends’ are the part of profit & loss appropriations and not an expense. Hence company does not save any tax on such amount.

Therefore, the company does not get any tax saving on the amount of dividends paid to the Shareholders and hence we do not take ‘after tax cost’ in case of Cost of Equity.