Question

What is the firm's cost of debt if 45% of total financing is debt, the rate is 10.00% and the tax rate is 35.00%?

• 3.50%

• 1.29%

• 2.93%

• 4.50%

Answer 1

Option (c) is correct.

Overall cost of financing is 10%. It includes cost of debt and cost of equity. Interest payments on debt or cost of debt are tax deductible. So, in real terms, cost of debt is the post tax cost of debt. Out of total financing, 45% is cost of debt (pre tax cost of debt).

So, Pre-tax cost of debt = 45% * 10% = 4.5%

We have to deduct tax from pre tax cost of debt to arrive at the cost of debt (or post tax cost of debt)

Tax rate = 35%

Post tax cost of debt = Pre tax cost of debt * ( 1- tax rate)

Post tax cost of debt = 4.5 % * ( 1- 35%)

Post tax cost of debt = 2.93%