Question

One of the advantages of borrowing is that interest is deductible for income tax purposes.

a) If a company pays 8 percent interest to borrow $500,000, but is in an income tax bracket that requires it to pay 40 percent income tax, what is the actual net-of-tax interest cost that the company incurs?

Answer 1

A company borrowing $500,000 at an 8% interest rate with a 40% tax bracket would have a net-of-tax interest cost of $24,000, after accounting for the tax deductibility of interest.

Step-by-step explanation:

The actual net-of-tax interest cost the company incurs can be calculated as follows:

Firstly, calculate the gross interest: $500,000 * 8% = $40,000

Then, determine the tax savings on interest: $40,000 * 40% = $16,000

Finally, subtract the tax savings from the gross interest to find the net-of-tax interest cost: $40,000 - $16,000 = $24,000

In conclusion, when considering a 40 percent income tax rate, the company's net-of-tax interest cost amounts to $24,000.