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% but 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 issuing debt involves adjusting the interest rate by the tax rate. For Issue 1, the after-tax cost is 5%*(1-0.4) = 3%. For Issue 2, the after-tax cost is simply the interest rate of 4%. Therefore, Issue 1 has a lower after-tax cost and is the preferred choice.

Laurentide Ski Resort Has to Make a Choice Between Two