Question

The Goodsmith Charitable Foundation, which is tax-exempt, issued debt last year at 9 percent to help finance a new playground facility in Los Angeles. This year the cost of debt is 25 percent higher; that is, firms that paid 11 percent for debt last year will be paying 13.75 percent this year.

a. If the Goodsmith Charitable Foundation borrowed money this year, what would the aftertax cost of debt be, based on their cost last year and the 25 percent increase?

b. If the receipts of the foundation were found to be taxable by the IRS (at a rate of 34 percent because of involvement in political activities), what would the aftertax cost of debt be?

Short answer

1. The after tax cost of debt is 11.25%
2. The after tax cost of debt is 7.425%.

Step-by-step solution

Step 1:

Debt cost this year (9*1.25) (a)	11.25%
Tax rate (b)	1
After tax cost of debt (a*b)	11.25%

Step 2:

Debt cost this year (9*1.25) (a)	11.25%
Tax rate (b)	0.66
After tax cost of debt (a*b)	7.425%