What happens to the after-tax cost of debt if the tax rate decreases?

The after-tax cost of debt is calculated using the formula: after-tax cost of debt = interest rate × (1 - tax rate). When the tax rate decreases, the impact on the after-tax cost of debt can be analyzed through this formula.

As the tax rate declines, the deduction received from that tax rate also decreases, which means that the amount subtracted from the interest rate becomes smaller. Consequently, the overall result is a higher after-tax cost of debt. This outcome occurs because the savings gained from the tax shield are diminished when the tax rate is lower. Therefore, with a decrease in the tax rate, the after-tax cost of debt increases.

Understanding this relationship is crucial for businesses as they make financing decisions, as a higher after-tax cost of debt can influence their choice of capital structure and financing options.