Question 13.2: By using the yield to maturity on General Electric’s debt, w...
By using the yield to maturity on General Electric’s debt, we found that its pretax cost of debt is 1.98%. If General Electric’s tax rate is 35%, what is its effective cost of debt?
Plan
We can use Eq. 13.3 to calculate General Electric’s effective cost of debt:
r_D(1-T_C) (13.3)
r_D=0.0198(pretax cost of debt)T_C=0.35(corporate tax rate)
Execute
General Electric’s effective cost of debt is 0.0198(1 – 0.35) = 0.01287 = 1.287%.
Evaluate
For every new $1000 it borrows, General Electric would pay its bondholders 0.0198($1000) = $19.80 in interest every year. Because it can deduct that $19.80 in interest from its income, every dollar in interest saves General Electric 35 cents in taxes, so the interest tax deduction reduces the firm’s tax payment to the government by 0.35($19.80) = $6.93. Thus, General Electric’s net cost of $1000 of debt is the $19.80 it pays minus the $6.93 in reduced tax payments, which is $12.87 per $1000 or 1.287%.