Marginal tax rate
Principles of Finance glossary · Cost of Capital & Capital Structure
Definition
The tax rate applied to the next dollar of taxable income. The relevant rate for WACC and for valuing tax shields, because both apply to incremental cash flows; the average effective tax rate is generally not appropriate for valuation work.
Marginal tax rate in plain English
Most tax systems tax you in tiers, so not every dollar you earn is taxed at the same rate; your marginal tax rate is the rate charged on the very NEXT dollar you earn. That is the rate that matters for business decisions, because when a company earns one more dollar or saves one more dollar in taxes, the effect happens at that top-tier rate, not at the lower blended average across all its income. For example, if extra profit is taxed at 25%, then every new dollar of interest expense that is tax-deductible saves the firm 25 cents, so that is the rate used to value tax savings and to compute the cost of capital. Using the average tax rate here would mis-price those next-dollar effects.
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