Question

High Road Tours has an after-tax cost of debt of 5.1 percent at its current tax rate of 34 percent. What will its after-tax cost of debt be if the tax rate drops to 21 percent? Assume all interest is tax deductible.

A) 6.10 percent

B) 5.92 percent

C) 6.17 percent

D) 4.03 percent

E) 4.47 percent

Answer 1

Option (A) is correct.

When the interest is tax deductible, then cost of debt is given by:

Cost of Debt = Interest Expense (1 – Tax Rate)

Now, putting the values in the cost of debt formula, we get,

5.1 % = Interest Expense (1- 34%)

5.1% = Interest Expense * 66%

Interest Expense = 5.1% / 66%

Interest Expense = 7.72

Now, the tax rate changes to 21%. Now, putting this value in the cost of debt formula, we get,

Cost of debt = 7.72 (1- 21%)

Cost of debt = 7.72 * 79%

Cost of debt = 6.10%