Reading 37, EOC #12

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!

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)

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