Reading 37, EOC #12

CFA Level I Corporate Finance
#1

Good morning,

This kept me up all night Sunday :slight_smile:

Maybe someone could walk me through the question:

  1. We find MV of debt and Equity - OK with this

  2. We determine capital structure - OK with this

  3. In calculating Cost of Debt - why do we adjust expected yield of the new issue by the company’s marginal tax rate? I get the idea that “debt payments are tax deducticble”, however, Im a bit shaky on the whole thing though.

–> If I were to think this way: YTM on a debt issue is how much the debt holders will earn, thus this is sort of a negative expense to the company, thus if payments are tax deductible, this will lower company’s cost of debt?!

Help me break down this concept please! Thanks!

#2

you need to look at it from the company’s point of view.

They paid out interest to their debt holders at a rate of rd, but received a cut due to Tax from the Government to the rate of rd*T.

So effectively they paid rd - rd*T = Rd (1-T)

#3

Thank you for the explanation. It should help me remember this.