In calculating the after-tax cost of debt within the weighted average cost of capital, which expression correctly reflects the after-tax cost of debt?

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Study for the Finance and Investment Challenge Test. Approaches include flashcards and multiple-choice questions with hints and explanations. Ready yourself to ace the exam!

Multiple Choice

In calculating the after-tax cost of debt within the weighted average cost of capital, which expression correctly reflects the after-tax cost of debt?

Explanation:
Interest on debt is tax-deductible, so the cost to the firm is reduced by the tax savings. The pre-tax cost of debt is r_d, and the after-tax effect reflects a tax shield of T times the interest, giving an effective cost of r_d × (1 − T). This is the figure used in WACC for the debt portion, often seen as D/V × r_d × (1 − T). The other expressions don’t fit: r_d ignores the tax shield, r_d + T adds taxes rather than accounting for their shield, and r_e × (1 − T) uses the cost of equity, not debt.

Interest on debt is tax-deductible, so the cost to the firm is reduced by the tax savings. The pre-tax cost of debt is r_d, and the after-tax effect reflects a tax shield of T times the interest, giving an effective cost of r_d × (1 − T). This is the figure used in WACC for the debt portion, often seen as D/V × r_d × (1 − T). The other expressions don’t fit: r_d ignores the tax shield, r_d + T adds taxes rather than accounting for their shield, and r_e × (1 − T) uses the cost of equity, not debt.

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