Question

one of the advantages of borrowing is that interest is deductible for income tax purposes. if a company pays 5 percent interest to borrow $500,000, but is in an income tax bracket that requires it to pay 30 percent income tax, what is the actual net-of-tax interest cost that the company incurs? what is the effective interest rate that is paid by the company?

Answer 1

The company's actual net-of-tax interest cost on borrowing $500,000 at a 5% interest rate while in a 30% tax bracket is $17,500, resulting in an effective interest rate of 3.5%.

Step-by-step explanation:

One of the advantages of borrowing is that interest is deductible for income tax purposes. If a company pays 5 percent interest to borrow $500,000, the gross interest cost is $25,000 (5% of $500,000). However, being in a 30 percent income tax bracket, the net-of-tax interest cost can be calculated by taking the interest paid and subtracting the tax savings from the interest deduction.

The tax savings is $25,000 × 30% = $7,500. So, the net-of-tax interest cost is $25,000 - $7,500 = $17,500. To find the effective interest rate paid by the company, divide the net-of-tax interest cost by the amount borrowed: $17,500 / $500,000 = 3.5%. Therefore, the actual net-of-tax interest cost the company incurs is $17,500, and the effective interest rate is 3.5%.