Calculate the after-tax cost of debt under each of the following conditions: a. A tax rate of...

Question:

Calculate the after-tax cost of debt under each of the following conditions:

a. A tax rate of 37%, and a yield to maturity of 7.9%

b. A tax rate of 25%, and a pre-tax cost of debt of 10.2%

c. A tax rate of 0%, and a yield to maturity of 7.9%

Debt Cost:

This question requires knowledge of monetary debt, which is an obligation due from a borrower to an investor. From the perspective of a corporate borrower, or issuer, the cost of debt is an important consideration in structuring an optimal capital structure.

Answer and Explanation:

This problem is fairly straightforward. The key is in understanding the following terms are synonymous: yield to maturity and pre-tax cost of debt. They both refer to the cost of servicing a debt, before consideration for taxes. Since interest expense is tax deductible, the after-tax cost of debt is the most relevant measure. It's computed as follows:

After-tax Cost of Debt = Effective Annual Interest Rate * (1 - Tax Rate)

The computations for the three scenarios are illustrated below.

a. After-tax Cost of Debt = .079 (1 - .37) = .049 or 4.9%

b. After-tax Cost of Debt = .102 (1 - .25) = .076 or 7.6%

c. After-tax Cost of Debt = .079 (1 - .00) = .079 or 7.9%


Learn more about this topic:

Loading...
Long-Term Debt: Definition, Cost & Formula

from Financial Accounting: Help and Review

Chapter 8 / Lesson 7
34K

Related to this Question

Explore our homework questions and answers library