Question

4. Assume the before-tax interest rate for a borrower is 8 percent and the marginal tax rate for that borrower is 25 percent. What is the after-tax interest rate? Show all work to be eligible for full credit. Explain why the after-tax interest rate is lower than the before-tax interest rate.

Answer 1

Before tax interest rate = 8%

marginal tax rate = 25% = 0.25

After tax Interest rate = Before tax interest rate * (1 - marginal tax rate)

= 8 * (1 - .25)

= 8 * .75

= 6 %

After tax interest rate is lower than interest rate because interest payments are tax deductible which makes debt a cost advantage . After tax interest rate is actually the interest paid less the tax saving resulting from tax drductible interest payment.we can understand by above example that borrowing saves taxes.