Estimating the Debt Interest Rate (DI) and the Tax Rate (T) is a necessary step in calculating the after-tax cost of debt ($K_D=I_D\times (1–T)$), an essential component of the Weighted Average Cost of Capital (WACC).
Here’s how to estimate these two parameters:

1. Estimate the Debt Interest Rate ( ${\mathbf{I}}_{\mathbf{D}}$)

To calculate a firm’s economic performance, the apparent interest rate is often taken by dividing the financial expenses by the average debt, or the rate given in the annual report is taken. It is, then, a kind of average historical rate consistent with the ROCE which calculates the economic profitability of historical investments.

To evaluate an investment, the rate to be used is not the average historical rate of past borrowings, but the  current marginal rate, i.e. the cost at which the company could take on debt today to finance a new project.

The estimation method is based on the addition of two components:

• The risk-free rate (RF): This corresponds to the yield on long-term government bonds (often 10 years) of the country in which the company operates or the project is carried out.
• The credit risk premium: This is the additional cost that creditors demand to lend to this specific company compared to the government. This bonus depends on the quality of the company’s signature (its rating).
  • Rating agencies provide ratings that correspond to specific default probabilities and risk premiums.
  • For a specific project, this rate is often the result of negotiation with local banks.

In summary:

${\mathbf{I}}_{\mathbf{D}}\mathbf{=}\mathbf{Risk}\mathbf{–}\mathbf{free}\mathbf{ }\mathbf{rate}\mathbf{ }\mathbf{(}\mathbf{Government}\mathbf{ }\mathbf{bonds}\mathbf{)}\mathbf{ }\mathbf{+}\mathbf{ }\mathbf{Credit}\mathbf{ }\mathbf{risk}\mathbf{ }\mathbf{premium}\mathbf{ }\mathbf{\left(}\mathbf{Spread}\mathbf{\right)}$

2. Estimate the Profit Tax Rate (T)

This rate is used to calculate the tax savings generated by the deductibility of financial expenses (the “tax shield”).

• The principle: For an investment, this is the corporate income tax (T) rate in force in the country where the project generates its profits. For a calculation of economic profits, the rate given in the annual report is taken or an apparent rate is calculated by dividing the tax by the taxable income.
• Deductibility check: It is crucial to check whether financial expenses are indeed tax deductible in the local context. In some countries or for certain legal structures, this deductibility may be capped or non-existent.
• Application: This rate applies to carrying charges to reduce the cost of debt. This is why the cost of debt embedded in the WACC is always lower than the nominal interest rate, as long as the company is profitable and pays taxes.

Example of calculation: If the risk-free rate is 4%, the risk premium is 3% and the tax rate is 30%:

• ID = 4% + 3% = 7%
• Net cost of debt = 7% × (1 – 30%) = 4.9%