This might come across as a stupid question. When calculating the cost of debt capital why is the cost (or interest payable) multiplied by 1 - tax rate? Interest is paid out of pre-tax profits, so why is tax deducted for calculating the cost of debt capital? I will quote from the notes: "The cost of debt capital should be taken as the cost in real terms of new borrowing by the company. This is calculated by taking an appropriate margin over the current expected total real return on index-linked bonds, having regard to the company's credit rating, and multiplying by (1-t), where t is the assumed rate of corporation tax" "This is because interest payments of C say, are paid out of pre-tax profits. Hence the effective cost to shareholders, in terms of the reduction in the post-tax profits that are available to pay dividends, is only (1-t) x C" I know I am missing a major point here. Just guide me through this.
Paying interest of, say, C: reduces the taxable profit by the same amount; the tax bill by C*t; and the profit after tax by C*(1-t). The cost to the shareholders is the reduction in their profit after tax which is C*(1-t). A subtle point in the notes is that you're only looking at your costs after tax
I get this. Will I be right if I say, if the company is made to pay tax on the interest payments, C, then the post tax profits would have been greater than C*(1-t)?
Yes. Remember that profit = Premium + Investment Income - Expenses - Claims + Change in Reserves - Interest Payments. Profit after tax is simply all these cashflows times (1-t).
