When you pay interest on one side, on the other side you save tax due to interest (because your profits gets reduced to the extent of interest).
Lets say, your profit before tax is 100 Mn and if you are paying interest of 30Mn (10% of 300Mn Loan), then your profit after interest is only 70Mn.
If this interest had not been there, you would have paid tax (lets say 30%) on 100Mn = 30Mn
But because of interest, your profit is 70Mn and you are to going to pay tax on 70Mn only - 70 x 30% = 21Mn
So, you have effectively saved 9Mn tax (30Mn - 21Mn).
This saving in tax is only because of interest.
This saving should be factored in interest cost while arriving at WACC.
I.E., You pay 30Mn on one side and save 9Mn on the other side - so you effectively pay only 21Mn as interest.
Earlier I said, 30Mn interest on 300Mn loan - i.e. 10%
But actually you have paid 21Mn on 300Mn loan. - it works out to 7% (21/300)
This is what after tax cost of debt formula does. It takes
Int x (1-tax rate)
10% x (1 - 30%)
10% x (1-0.30)
10% x 0.70 = 7%
CA N Raja
A Chartered Accountant with tonnes of passion for teaching.