Chapter 9.2, Problem 9.7RQ

Summary Introduction

To discuss:

How is the before-tax cost converted to after-tax costs.

Introduction:

The before tax cost of debt is defined as the rate of return the firm must pay on new borrowing. If a firm has zero floatation costs, then the firm’s before-tax cost of debt would be equal to required rate of return by the bondholders. The interest payments made to the bondholders are tax deductible for the firm. The interest expenses on firm reduce the taxable income and the tax liability of the firm.