Question

Terrier Company is in a 40 percent tax bracket and has a bond outstanding that yields 10 percent to maturity. a. What is Terrier’s aftertax cost of debt? b. Assume that the yield on the bond goes down by 1 percentage point, and due to tax reform, the corporate tax rate falls to 25 percent. What is Terrier’s new aftertax cost of debt? c. Has the aftertax cost of debt gone up or down from part a to part b? Explain why

Short answer

Cost of debt is 6%

New cost of debt is 7.65%

Cost of debt increase as fall in the tax rate.

Step-by-step solution

a.

$\begin{array}{rcl}\mathrm{Kd}\left(\mathrm{Cost}\mathrm{of}\mathrm{debt}\right)& =& \mathrm{Yield}\left(1-\mathrm{Tax}\mathrm{Rate}\right)\\ & =& 10\%\times \left(1-40\%\right)\\ & =& 10\%\times 0.60\\ & =& 6\%\end{array}$

6% is Terrier’s aftertax cost of debt.

b.

$\begin{array}{rcl}\mathrm{Kd}\left(\mathrm{Cost}\mathrm{of}\mathrm{debt}\right)& =& \mathrm{Yield}\left(1-\mathrm{Tax}\mathrm{Rate}\right)\\ & =& 9\%\times \left[1-\left(40-25\right)\%\right]\\ & =& 9\%\times 0.85\\ & =& 7.65\%\end{array}$

7.65% is Terrier’s new aftertax cost of debt.

c.

Businesses can deduct interest costs from their taxes. As a result, the net debt cost of a company is the amount of interest paid less the amount saved in taxes. Although from part a to b, the yield or interest rate decreases, the tax rate also decreases significantly, so the cost of debt increases.