CFA Level ICorporate IssuersEasy
A company issues bonds with a yield to maturity of 8%. The company's marginal tax rate is 30%. What is the company's after-tax cost of debt for use in the WACC calculation?
- A2.4%
- B8.0%
- C5.0%
- D5.6%
Show answer & explanationAnswer & explanation
Correct answer: D. 5.6%
After-tax cost of debt = YTM × (1 − tax rate) = 8% × (1 − 0.30) = 8% × 0.70 = 5.6%.
Why the other options are wrong
- A. This is only the tax savings portion (8% × 0.30), not the after-tax cost.
- B. This is the pretax cost of debt, ignoring the tax shield.
- C. Does not correctly apply the (1 − tax rate) adjustment.
After-Tax Cost of Debt
The effective cost to a firm of borrowing after accounting for the tax deductibility of interest payments.
- Formula: rd × (1 − tax rate)
- Interest expense reduces taxable income, creating a tax shield
- Always lower than the pretax cost of debt when tax rate > 0
Memory trick: Taxes take a bite out of the cost of debt