You are trying to determine your firm's cost of debt capital.  The only debt on the balance sheet is a series of bonds that the firm has issued.  The bonds are not frequently traded, and therefore it is not possible to determine the market price.

The following table shows various debt ratings, along with an analyst's estimate of the credit spread for the ratings shown.  Standard and Poor's have given your firm an A debt rating.  The risk-free rate of return is 2.5% and the corporate tax rate is 30%.  What is your firm's after-tax cost of debt capital?

 

     Debt Rating    	     Credit Spread    
AAA	40 bp
AA	60 bp
A	80 bp
BBB	100 bp
BB	120 bp
Question 5Answer

a.
2.3%

b.
1.3%

c.
0.9%

d.
3.3%

To calculate the **after-tax cost of debt capital**, we will follow these steps:

1. **Determine the pre-tax cost of debt**:  
   The pre-tax cost of debt is equal to the risk-free rate plus the credit spread associated with the firm’s debt rating. Your firm has an **A** debt rating, and the corresponding credit spread is **80 basis points (bp)**, which is 0.80%.

   \[
   \text{Pre-tax cost of debt} = \text{Risk-free rate} + \text{Credit spread}
   \]
   \[
   \text{Pre-tax cost of debt} = 2.5\% + 0.80\% = 3.30\%
   \]

2. **Calculate the after-tax cost of debt**:  
   The after-tax cost of debt takes into account the tax shield provided by interest payments. This is calculated by multiplying the pre-tax cost of debt by \((1 - \text{tax rate})\).

   \[
   \text{After-tax cost of debt} = \text{Pre-tax cost of debt} \times (1 - \text{Tax rate})
   \]
   \[
   \text{After-tax cost of debt} = 3.30\% \times (1 - 0.30) = 3.30\% \times 0.70 = 2.31\%
   \]

Therefore, the after-tax cost of debt capital is approximately **2.3%**.

The correct answer is:
- **a. 2.3%**

Would you like any more details, or do you have questions? Here are some related questions to deepen your understanding:

1. How does the credit spread affect the cost of debt?
2. Why does the tax shield reduce the cost of debt for firms?
3. What factors influence a firm's debt rating?
4. How would a change in the risk-free rate affect the cost of debt?
5. How do corporate taxes impact a firm's capital structure decisions?

**Tip:** Firms with higher debt ratings benefit from lower credit spreads, which in turn reduces their cost of debt financing.

You are trying to determine your firm's cost of debt capital. The only debt on the balance sheet is a series of bonds that the firm has issued. The bonds are not frequently traded, and therefore it is not possible to determine the market price.

The following table shows various debt ratings, along with an analyst's estimate of the credit spread for the ratings shown. Standard and Poor's have given your firm an A debt rating. The risk-free rate of return is 2.5% and the corporate tax rate is 30%. What is your firm's after-tax cost of debt capital?

Debt Rating         Credit Spread
AAA  40 bp
AA  60 bp
A  80 bp
BBB  100 bp
BB  120 bp

Answer choices:
a. 2.3%
b. 1.3%
c. 0.9%
d. 3.3%

Determine your firm's after-tax cost of debt capital for A-rated bonds. Learn to calculate the pre-tax cost of debt using a risk-free rate of 2.5% and an 80 bp credit spread, followed by the after-tax cost of debt with a 30% corporate tax rate. Suitable for undergraduate finance students.

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