Chapter 5

5.2. Cost of Bank Loans

When a firm borrows money at a stated rate of interest from a bank, determining
the real cost rate of the debt is relatively straightforward. Because the interest paid on
bank loans is a tax-deductible expense, the firms cost rate is less than the required rate of
interest of the suppliers of debt capital. The explanation is the same as in the case of bond
credits. Under the incidence of the taxes, the interests are deductible of the taxable
profit and the real load undertaken by the company is smaller, that is if the debtor
company is profitable, the interest that it will deliver each year to its lender will allow
realizing tax shield.
In this case:
The after-tax % cost of debt (real rate of cost) = nominal interest rate * (1 T)
T Corporate income tax rate
Observation: If the debtor company is not profitable, the real cost rate equals the
nominal interest rate paid to the bank, because in this case there are no tax savings.
EX:
Beta Inc. has decided to borrow 1 mil.$ from their local bank for a 2 year period.
The bank will charge them 13,5% for this loan. Returning modality: reimbursement is
made entirely and the end of those 2 years. The corporate income tax rate is 40%. The
firm has no profit. What is the real cost rate of this loan for the firm?
The real cost rate of the bank loan is found by solving the equation:
NPV = 0
0,135mil. 0,135mil. 1mil.

1mil. 0
1 r
1 r 2

Solution : r = 13,5%
EX.2.:
Determine the real cost rate for the above mentioned bank loan if the returning modality
is: proportional reimbursement in time.
The real cost rate of the bank loan is found by solving the equation:
0,135mil. 0,500mil. 0,0675mil. 0,500mil.

1mil. 0
1 r
1 r 2

Solution : r = 13,5%
We can observe that the returning modality has no influence on the real cost rate.

EX.3.:
Determine the real cost rate for the above mentioned bank loan if the company is
profitable and the returning modality is: proportional reimbursement in time.
The real cost rate of the bank loan is found by solving the equation:
0,135mil . 0,135mil. * 40% 0,500mil. 0,0675mil. 0,0675mil. * 40% 0,500mil.

1mil. 0
1 r
1 r 2

Solution: r = 8,1%
So, the 13,5% interest paid to the bank costs the profitable firm only 8,1% since the
interest is tax-deductible, and generates tax savings.