For a company with positive pre-tax earnings and a 35 percent income tax rate, a new debt issue that increases interest by $500,000 would cost the company ____.

Question

Quizplus · Accepted Answer

Since the company has positive pre-tax earnings and a 35% income tax rate, the interest expense on the new debt issue would be tax-deductible. Thus, the after-tax cost of the debt would equal the interest expense minus the tax savings. The tax savings will be equal to 35% of the interest expense since the company can deduct the interest expense from its taxable income. Therefore, the after-tax cost of the debt issue would be $500,000 - (0.35 x $500,000) = $325,000.

For a Company with Positive Pre-Tax Earnings and a 35