Laurentide Ski Resort has to make a choice between two different debt issues.Issue 1 has an interest rate of 5% and the interest is tax deductible.Issue 2 has an interest rate of 4% however the interest is not tax deductible.If the firm has a tax rate of 40%, which issue is preferred and why?
A)Issue 2 because the interest rate of 4% is less than the 5% of issue 1.
B)Issue 1 because the after-tax cost is 3% while the after-tax cost of issue 2 is 4%
C)Issue 1 because the after-tax cost is 2% while the after-tax cost of issue 2 is 4%
D)Issue 2 because the after-tax cost is 1.6% while the after-tax cost of Issue 1 is 2%

Question

Quizplus · Accepted Answer

The after-tax cost of issue 1 is 5% x (1 - 0.4) = 3%, while the after-tax cost of issue 2 is 4%. Therefore, issue 1 is preferred because it has a lower after-tax cost.

Laurentide Ski Resort Has to Make a Choice Between Two