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 An important aspect of cost debt is the tax effect. As the interest on debt is tax deductible, the firm gets a saving in its tax liability. The interest work as a tax-shield and the tax liability of the firm is reduced. Thus, the effective cost of debt is lower than the interest paid to debt investors. The amount of tax saving and the effective cost of debt depend on the tax rate. The net cost of interest to the firm (at least for those with sufficient profits that are liable for taxes) is the annual interest multiplied by a factor of (1- tax rate). The real cost of debt is determined only after considering this tax shield as follows:

                 kd  =  ki ( 1 – t )

where     kd  =  Cost of capital of debt (after tax)
                ki   =  Cost of capital of debt( before tax)
                t    =   Tax rate

It may be noted that the tax benefit of interest deductibility is available only if the firm is a profit making one. For a loss making firm or for a no- tax paying firm, this tax adjustment is not required and in such a case the k d  =  k  i.  The tax deductibility reduces the cost of debt to a net amount after prevailing tax rate is applied.

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