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

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 $500,000, but is in an income tax bracket that requires it to pay 40 percent income tax, what is the actual net-of-tax interest cost that the company incurs? (Omit the "$" sign in your response.) Actual net-of-tax interest cost $ b. What is the effective interest rate that is paid by the company? (Round your answer to 1 decimal place. Omit the "%" sign in your response.) Effective interest rate

Explanation / Answer

Gross interest paid = 8% * 500,000 = $40,000 tax savings = 40% * 40,000 = $16,000 net-of-tax interest cost = gross interest - tax savings = 40,000 - 16,000 = $24,000 Effective interest rate = actual rate * (1 - tax rate) = 8% * (1 - .4) = 4.8% Another way to calculate effective interest rate = net-of-tax cost / amount borrowed = 24,000 / 500,000 = 4.8%

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