What does it mean for income bonds to have deductibility of interest paid from the company's taxable income? And why does this deductibility cut the cost of that form of capital in half?
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I'm not sure how you get to "cut the cost of that form of capital in half" unless the tax rate is 50%. Is there more context that would explain that part?– D StanleyCommented Jul 17, 2020 at 14:37
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@DStanley I think the 50% referred to the personal tax rate, I got the question from the book The Intelligent Investor– Sean TaylorCommented Jul 17, 2020 at 18:55
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I don't think the quote is referring to personal income/taxes at all, but it's hard to know without the full context.– D StanleyCommented Jul 17, 2020 at 20:13
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1 Answer
Interest payments are deductible expenses for the company, which reduces their cost of capital. For example, If they have a 5% coupon and a 20% tax rate, the after-tax interest that they pay is 4%.
I'm not sure how you get to "cut the cost of that form of capital in half" unless the tax rate is 50%.
answered Jul 17, 2020 at 14:37
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Ok, so before a company receives interest they have on a bond, the interest income is taxed at corporate rates? Commented Jul 17, 2020 at 18:55
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No, when a company pays interest one the bonds it's issued, it can deduct that from its taxes. Similar to how an individual can deduct mortgage interest. Commented Jul 17, 2020 at 20:13
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Ok so if a company has to pay $100 in interest, and it owes $1000 in taxes, it now only owes $900 in taxes? What's the benefit to the holder of the income bond vs other bonds? Commented Jul 17, 2020 at 20:17
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I should have said it can deduct it from it's taxable income. So if it has $1000 in income and pays $100 in interest, it now only pays tax on $900 of income. Commented Jul 17, 2020 at 20:33
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There's really no direct benefit to the owner of the bond - that's why I wonder what the full context is. Is the book saying that these bonds benefit the bondholders because the company can deduct the interest? Commented Jul 17, 2020 at 20:34