Question

?After-tax cost of debt??Personal Finance Problem??

Bella Wans is interested in buying a new motorcycle. She has decided to borrow the money to pay the ?$30,000 purchase price of the bike. She is in the 33?% federal income tax bracket. She can either borrow the money at an interest rate of 7?% from the motorcycle? dealer, or she could take out a second mortgage on her home. That mortgage would come with an interest rate of 7?%. Interest payments on the mortgage would be tax deductible for? Bella, but interest payments on the loan from the motorcycle dealer could not be deducted on? Bella's federal tax return.

a. Calculate the ?after-tax cost of borrowing from the motorcycle dealership.

b. Calculate the ?after-tax cost of borrowing through a second mortgage on? Bella's home.

c. Which source of borrowing is less costly for? Bella?

d. Is there any other consideration that Bella ought to think about when deciding which loan to take out to pay for the? motorcycle?

Answer 1

a) After tax cost of borrowing from the motorcycle dealership - The interest paid on motor cycle dealership cannot be deducted for calculating the taxable income - Therefore the cost of debt will be 7%

b) After tax cost of borrowing from the second mortgage = 0.07*(1-0.33) = 0.0469 = 4.69%

c) The borrowing through second mortgage would be less costly for Bella as it would received deduction on interest paid in income tax and the after tax cost debt is 4.69%

d) The other consideration that Bella will have to ought to think about when deciding which loan to take out to pay for the motorcycle is that if she is not able to make the payment under second mortgage there would be a risk of she losing her house.