Question

Western Gas & Electric Company (WGC) can borrow funds at an interest rate of 12.50% for a period of five years. Its marginal federal-plus-state tax rate is 45%. What is WGC's after-tax cost of debt?

Answer 1

Cost of debt refers to the effective rate a company pays on its current debt.
However, we take after tax cost of debt into consideration, given the tax deductibity of interest expenses. That is interest expenses are reduced from company's earnings before calculation of taxes. So, interest expenses reduces taxable income (unlike dividends, which are paid after paying taxes)

After tax cost of debt = Pretax cost of debt * (1 - Tax Rate)

After tax cost of debt = 12.50% * (1 - 45%) = 6.875% --> Answer