Cost of debt and the tax shield: what borrowing costs after tax
The cost of debt is what a company would pay today to borrow, and because interest is deducted before tax, what it really costs is less. This lesson shows how to find the rate, how the tax shield works and where it stops working, and applies both to Apple's notes, commercial paper and tax rate.
- Level
- Beginner
- Reading time
- About 25 minutes
- Know this first
- Debt, equity and capital structure
By the end you will be able to:
- say what the cost of debt is and why the coupon on old bonds is the wrong guide
- calculate the after-tax cost of debt and the interest tax shield
- explain when the shield is smaller than the tax rate suggests
- apply the formula to a real company's borrowing and tax rates
What borrowing really costs
The cost of debt is the rate a company must pay today to borrow more money for the same term and risk. It is a forward-looking figure. It is not the coupon on bonds issued years ago, nor the interest paid last year divided by the debt, although both are clues. Last lesson showed that the same business earns different returns for its owners depending on whether it borrows. To judge that choice, and to value projects later in this module, you need the price of the debt as a percentage.
There is a second step that makes debt cheaper than it first looks. In most countries a company deducts interest before it works out the profit on which it pays tax, so each dollar of interest saves tax. The cost that matters for decisions is therefore the cost after tax.
Finding the cost before tax
Three routes lead to the pre-tax cost of debt, and they are all about the same thing: what lenders charge for new money.
- The yield on the company's own bonds. As the bond lesson showed, the yield to maturity is the return buyers of the bond earn today. For a company with traded bonds this is the cleanest estimate, because it is the market's current price for lending to that company.
- A safe rate plus a spread. Start from the yield on government bonds of the same term, then add a margin for the chance the company does not pay. Stronger companies pay a smaller margin, called the credit spread.
- The rate on a recent loan or bond issue. The interest rate on notes the company has just sold is current market evidence for its own borrowing.
What not to use is the average rate on all existing debt. It reflects rates ruling when each loan was taken, which may be long ago. A company that borrowed at 1% in a low-rate year does not get to borrow at 1% today.
The tax shield on interest
Suppose a business earns operating profit of $200,000 and pays tax at 21%. With no debt the tax is $42,000 and profit after tax is $158,000. Now suppose it borrows $500,000 at 5% and pays $25,000 in interest. Profit before tax falls to $175,000, so the tax falls to $36,750. The company has paid $25,000 in interest but saved $5,250 in tax, so the interest has cost it only $19,750 after tax, which is 3.95% of the $500,000 borrowed. The tax saved is the interest tax shield.
The shield is worth interest times the tax rate. A higher tax rate means a larger shield and a cheaper after-tax cost, and where there is no tax there is no shield.
See the shield at work
Set the debt, its interest rate, the tax rate and the operating profit. The left page shows the interest, the tax saved and the real cost after tax. The right page shows the tax bill and profit with and without the debt. All amounts are made up for teaching.
Borrowing $500,000 at 5.00% costs $25,000 in interest. It lowers the tax bill from $42,000 to $36,750, a saving of $5,250, so the cost after tax is $19,750, or 3.95% of the debt. Profit after tax falls from $158,000 to $138,250, by $19,750, which is less than the interest paid.
Four experiments. First, set the tax rate to 0%. The shield disappears and the cost after tax equals the 5% rate. Second, raise tax to 40%. The shield rises to $10,000 and the cost after tax falls to 3.00% of the debt. Third, return to 21% and cut operating profit to $20,000. Interest of $25,000 is now larger than the profit, so the business pays no tax with the debt, and the shield is only $4,200, the tax it would have paid without it, not the $5,250 a full shield would give. Fourth, raise the interest rate to 8% with the other settings back at their defaults. The cost after tax is 6.32%, up from 3.95%, but still below the 8% printed on the loan.
When the shield is smaller than it looks
- The company needs taxable profit. The experiment with $20,000 of profit shows it. A loss-making business gets no immediate saving, though some countries let losses be carried forward.
- Interest deductions are often capped. Many countries limit how much interest can be deducted, usually by reference to profit.
- Which tax rate counts is a judgement. The shield is worth the rate at which the next dollar of profit would be taxed. A company's average, or effective, rate can differ from that marginal rate, and the two can be far apart for a company that operates in several countries.
- Debt has costs beyond interest. A company that borrows too much faces a higher interest rate, legal costs of default and a loss of flexibility. The shield is one side of a trade-off.
Apple's cost of debt
Apple's reports give what is needed to put numbers on all of this. Its debt note shows that the notes it issued in 2025 carry effective interest rates of 4.07% to 4.83%, and that notes issued across 2013 to 2023 range from 0.03% to 5.75%. Its commercial paper, short-term borrowing, had a weighted average rate of 4.19% at the end of fiscal 2025. The first of these is the best measure of what new long-term borrowing costs Apple today, and they are higher than the average on its older debt, which the lesson on bond pricing used to explain why the notes' fair value is below the amount owed.
For tax, the income statement gives provision for income taxes of $20,719 million on income before tax of $132,729 million in fiscal 2025, an effective rate of 15.6%. For fiscal 2024 the provision was $29,749 million on $123,485 million, a rate of 24.1%, but that includes a one-time charge of $10.2 billion that Apple says relates to a European State Aid decision. Without it the fiscal 2024 rate would have been 15.8%. So the underlying rate is close to 15.6% in both years, below the 21% US federal statutory rate.
| Apple borrowing | Rate before tax | After tax at the effective rate (15.6%) | After tax at the 21% statutory rate |
|---|---|---|---|
| Notes issued in 2025, lowest rate | 4.07% | 3.43% | 3.22% |
| Notes issued in 2025, highest rate | 4.83% | 4.08% | 3.82% |
| Commercial paper, weighted average at year end | 4.19% | 3.54% | 3.31% |
| Older notes, lowest effective rate (issued 2013 to 2023) | 0.03% | 0.03% | 0.02% |
| Older notes, highest effective rate (issued 2013 to 2023) | 5.75% | 4.85% | 4.54% |
The table applies the formula to Apple's own figures. A 2025 note at 4.07% costs 3.43% after tax at Apple's effective rate and 3.22% at 21%. At 4.83% the figures are 4.08% and 3.82%. Which tax rate is right is a real question. If the next dollar of Apple's interest would reduce profit taxed at 21%, the larger shield applies. If the effective rate is a better guide to the tax saved, the smaller does. The answer changes the after-tax cost by about 0.26 points, which is why an analyst should state the rate used.
On the scale of the business, Apple expects to pay about $2.6 billion of interest on its notes over the next 12 months, according to its report. At the effective rate that interest saves about $406 million of tax, and at 21% about $546 million. Against operating profit of $133,050 million that is small. For Apple the tax shield is a minor benefit, not the reason the company borrows.
What the cost of debt cannot tell you
- It is the cost of one kind of money. It says nothing about the owners' required return, which is higher and is the subject of the next lesson.
- It changes with the market. A cost measured in a quiet market can be wrong a year later.
- It depends on the loan's terms. A secured loan, a long one and a loan with covenants are each priced differently.
- The shield assumes the company pays tax. Where tax is deferred or avoided, the shield is worth less.
The shield depends on the tax rate
Interest on a loan is usually deductible before tax is calculated, so the government bears part of the cost. The after-tax cost of debt is the interest rate multiplied by one minus the tax rate. The table uses the effective tax rate each company paid in its latest year, taken from its income statement, and assumes a loan at 5% for all three so that only the tax rate differs. The 5% is an illustration and not a rate any of them paid.
| Latest year | Effective tax rate | Tax saved per 100 of interest | After-tax cost of a 5% loan |
|---|---|---|---|
| Apple | 15.6% | 15.6 | 4.22% |
| Microsoft | 17.6% | 17.6 | 4.12% |
| Toyota | 25.3% | 25.3 | 3.73% |
At Toyota's effective rate of 25.3%, each 100 of interest saves 25.3 in tax, against 15.6% for Apple and 17.6% for Microsoft. The same loan costs a company that pays tax at a higher rate less after tax. This is why corporate tax rates have a direct effect on the funding choice: the higher the rate, the more attractive debt looks, and the lower the rate, the less the shield is worth.
Limits on the deduction
Governments do not allow unlimited deductions. Many countries cap net interest deductions as a share of earnings, to stop multinationals from shifting profit by borrowing in high-tax countries. The OECD recommended that countries adopt a fixed ratio rule with a limit set in a corridor of 10% to 30% of earnings, and the European Union and the United Kingdom have adopted a cap of 30%. The details differ by country, including how earnings are measured and what exemptions apply.
A hypothetical shows the effect. A company has earnings before interest, tax, depreciation and amortisation of 400, pays interest of 150, and faces a 25% tax rate with a cap of 30% of earnings. The deduction is limited to 120, so 30 of the interest is not deductible in the year. The tax saved is 30 and not the 37.5 that the full shield would give, so the after-tax cost of the interest is 120, or 80% of the interest, instead of 75%. For a company with high debt and modest earnings, the shield can be smaller than the simple formula says.
What a company actually pays
The cost of debt in the formula is the rate on new borrowing, not the historical average. A rough check from the accounts divides interest paid by borrowings. Toyota paid ¥1,609,083 million of interest on ¥38,792,879 million of year-end borrowings, an average of 4.1%. That is a blend of old and new loans in many currencies, and the borrowings figure is an end-of-year balance, so the result is approximate. Toyota also received ¥2,672,724 million of interest, more than it paid, because its finance arm lends to customers. The average cost can lag current market rates in either direction. When rates have risen since the loans were taken, the market cost of new debt is higher than the accounts show, and the reverse when rates have fallen.
Common mistakes
Using the coupon on old bonds as today's cost
Apple's older notes carry rates as low as 0.03%. That tells you what it paid then, not what it would pay now.
Forgetting the tax adjustment
Interest of 5% does not cost 5%. At a 21% tax rate it costs 3.95%.
Applying the shield without profit
If operating profit is below interest, only part of the interest saves tax this year.
Using the wrong tax rate
Be clear whether you use the statutory, marginal or effective rate, and say so.
Treating the shield as a reason to borrow without limit
The saving is a fraction of the interest. The rest is real cost, and heavy borrowing raises both the rate and the risk.
Try it yourself
1. A company borrows at 6% and pays tax at 25%. What is the after-tax cost of debt?
Show the working
6% × (1 − 0.25) = 4.5%.
2. A company pays $80,000 of interest and has plenty of profit. Tax is 30%. How much tax does the interest save, and what does it cost after tax?
Show the working
Tax saved = 80,000 × 0.30 = $24,000. Cost after tax = 80,000 − 24,000 = $56,000.
3. A bond with a face value of $1,000 and a 3% coupon trades at a yield of 5%. A company wants to know its cost of debt. Which rate, 3% or 5%, should it use, and why?
Show the working
5%. The yield is what the market demands for lending to the company today. The 3% coupon is a historical rate on a bond that now sells below face value.
4. Apple's commercial paper had a weighted average rate of 4.19% at the end of fiscal 2025. At its effective tax rate of 15.6%, what does it cost after tax?
Show the working
4.19% × (1 − 0.1561) = 3.54%.
Where this is used
- A finance team uses the after-tax cost of debt in the cost of capital, covered two lessons from now, to set the rate for judging projects.
- A lender or rating agency compares the interest a borrower pays with its profit to judge whether the debt can be carried.
- An analyst checking a company's debt note compares the rate on new notes with the older average to see how funding costs are changing.
- A tax adviser estimates how much of a new loan's interest will actually be deductible.
Key terms
- Cost of debt
- The rate a company would have to pay today to borrow, for the same term and risk.
- Credit spread
- The extra yield over a safe government bond that a borrower pays for the risk of not repaying.
- Interest tax shield
- The tax saved because interest is deducted before profit is taxed.
- After-tax cost of debt
- Interest rate × (1 − tax rate).
- Effective tax rate
- Tax expense divided by profit before tax.
- Statutory tax rate
- The rate set by law, before reliefs and differences between countries.
- Marginal tax rate
- The rate of tax paid on the next dollar of profit.
Questions people ask
Is the coupon rate the cost of debt?
Only for a bond issued today at par. For an older bond, the cost of debt is the current yield, which can differ a lot from the coupon.
Why is debt cheaper than equity?
Lenders are paid first and have a fixed claim, so they take less risk and ask for less. In addition, interest is tax deductible while dividends are not.
Does a company really save tax because of interest?
Yes, if it has taxable profit against which to deduct the interest. Rules limiting deductions can reduce the saving.
Why does Apple's tax rate look low?
Its effective rate reflects the mix of countries where profit is earned and various reliefs. The report gives the detail in its tax note, which this lesson does not reproduce.
Sources and review
- Apple Inc., Form 8-K, Exhibit 99.1: fourth quarter and full-year fiscal 2025 results, filed with the US Securities and Exchange Commission. Source of income before tax, provision for income taxes and the note on the one-time charge in fiscal 2024.
- Apple Inc., Form 10-K for the fiscal year ended 27 September 2025. Source of the commercial paper rate and the expected interest on the notes.
- EDGAR Tools, Apple long-term debt disclosures, a data site that reproduces the debt note, for the effective interest rates.
- ACCA, Bond valuation and yields, for the use of yield as the market cost of debt.
- Corporate Finance Institute, Capital structure, for the tax advantage of debt.
- Apple Inc., Form 8-K, Exhibit 99.1: fourth quarter and full-year fiscal 2025 results, filed with the US Securities and Exchange Commission. Source of Apple's statements.
- Microsoft Corporation, Form 8-K, Exhibit 99.1: fourth quarter and fiscal year 2025 results, filed with the US Securities and Exchange Commission. Source of Microsoft's statements.
- Toyota Motor Corporation, FY2025 Financial Summary (IFRS, unaudited, in millions of yen), furnished to the US Securities and Exchange Commission on Form 6-K. Source of Toyota's statements.
- KPMG, BEPS Action 4: limiting base erosion involving interest deductions, for the OECD recommended corridor of 10% to 30% for a fixed ratio rule and the 30% cap adopted in the EU and UK.
How the numbers were checked: Apple's income statement was tied out by code, and effective tax rates were recomputed from the printed provision and pre-tax income, with fiscal 2024 also computed without the one-time charge. The calculator was tested against separate arithmetic for 180 combinations of debt, rate, tax and profit, including that profit lost to the debt equals interest less tax saved, and that the shield equals interest times the tax rate whenever profit covers interest.