Arnot Corporation reported $25,000 in interest expense on loans of $312,500, $120,000 in net income and $40,000 in income tax expense last year.What was their after-tax cost of borrowing and their interest coverage ratio for the year? $$\begin{array}{l}

\begin{array} { c c c }
&\text { After-tax }&\text {cost Interest }\
& \text { of borrowing } & \text { Coverage ratio } \
\hline \text { A) } & 6 \% & 7.4 \
\text { B) } & 6 \% & 12.5 \
\text { C) } & 8 \% & 7.4 \
\text { D) } & 8 \% & 12.5
\end{array}
\end{array}$$

Question

Arnot Corporation reported $25,000 in interest expense on loans of $312,500, $120,000 in net income and $40,000 in income tax expense last year.What was their after-tax cost of borrowing and their interest coverage ratio for the year? $$\begin{array}{l}

\begin{array} { c c c } 
&\text { After-tax }&\text {cost Interest }\
& \text { of borrowing } & \text { Coverage ratio } \
\hline  \text { A) } & 6 \% & 7.4 \
\text { B) } & 6 \% & 12.5 \
\text { C) } & 8 \% & 7.4 \
\text { D) } & 8 \% & 12.5
\end{array}
\end{array}$$

Quizplus · Accepted Answer

The after-tax cost of borrowing is calculated as the interest expense after tax divided by the total loan amount. The interest coverage ratio is calculated as EBIT (Earnings Before Interest and Taxes) divided by interest expense. 1. **After-tax cost of borrowing**: The tax shield on the interest expense is $25,000 * (income tax rate). The income tax rate can be found by dividing the income tax expense by the pre-tax income (net income + income tax expense), which is $40,000 / ($120,000 + $40,000) = 1/4 or 25%. Thus, the after-tax interest expense is $25,000 * (1 - 0.25) = $18,750. The after-tax cost of borrowing is then $18,750 / $312,500 = 6%.2. **Interest Coverage Ratio**: EBIT is net income + interest expense + income tax expense = $120,000 + $25,000 + $40,000 = $185,000. The interest coverage ratio is then $185,000 / $25,000 = 7.4.Therefore, the correct answer is 6% for the after-tax cost of borrowing and 7.4 for the interest coverage ratio, which matches option A.

Arnot Corporation Reported $25,000 in Interest Expense on Loans of $312,500