In order to finance a new project, a company borrowed $4,000,000 at 8% per year with the stipulation that the company would repay the loan plus all interest at the end of one year. Assume the company’s effective tax rate is 39%. What was the company’s cost of debt capital (a) before taxes, and (b) after taxes? (c) Compare the calculated after-tax cost with the approximated cost using Equation [10.4].
What will be an ideal response?
(a) Before-tax cost of debt capital is 8%
(b) Interest = 4,000,000(0.08)
= $320,000
Tax savings = 320,000(0.39)
= $124,800
Before-tax repayment = 4,000,000(1.08) = $4,320,000
After tax repayment = 4,320,000 – 124,800 = $4,195,200
0 = 4,000,000 – 4,195,200(P/F,i*,1)
i* = 0.488 (4.88%)
After-tax cost = 4.88%
(c) Approximation using Equation [10.4] is
After-tax cost of debt capital = 8%(1 - 0.39) = 0.488 (4.88%)
In this case, the approximation is the same as the actual calculated result
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