If a company's pretax cost of debt is 8% and the tax rate is 36%, what is the after-tax cost of debt?

If a company's pretax cost of debt is 8% and the tax rate is 36%, what is the after-tax cost of debt?

• A. 4.88%
• B. 5.12%
• C. 8.00%
• D. 12.00%

Answer: (B)

To determine the after-tax cost of debt, you apply the formula: After-tax cost of debt = Pretax cost of debt × (1 - Tax rate) In this scenario, the pretax cost of debt is 8%, or 0.08 in decimal form, and the tax rate is 36%, or 0.36 in decimal form. Using the formula: After-tax cost of debt = 0.08 × (1 - 0.36) = 0.08 × 0.64 = 0.0512 Converting this back to a percentage gives us 5.12%. This calculation is critical because the after-tax cost of debt reflects the true expense of borrowing for a company, considering the tax shield that debt provides. Interest on debt is a tax-deductible expense, thus reducing the effective cost of debt for the firm. The other options do not represent the correct application of the after-tax concept. The answer of 5.12% aligns accurately with financial principles and the provided data, demonstrating a solid understanding of how tax impacts borrowing costs.

To determine the after-tax cost of debt, you apply the formula:

After-tax cost of debt = Pretax cost of debt × (1 - Tax rate)

In this scenario, the pretax cost of debt is 8%, or 0.08 in decimal form, and the tax rate is 36%, or 0.36 in decimal form.

Using the formula:

After-tax cost of debt = 0.08 × (1 - 0.36)

= 0.08 × 0.64

= 0.0512

Converting this back to a percentage gives us 5.12%.

This calculation is critical because the after-tax cost of debt reflects the true expense of borrowing for a company, considering the tax shield that debt provides. Interest on debt is a tax-deductible expense, thus reducing the effective cost of debt for the firm.

The other options do not represent the correct application of the after-tax concept. The answer of 5.12% aligns accurately with financial principles and the provided data, demonstrating a solid understanding of how tax impacts borrowing costs.