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?
To calculate the actual net-of-tax interest cost, you need to consider the income tax deduction for interest payments. The formula for calculating this cost is:
Actual net-of-tax interest cost = Interest cost * (1 - Tax rate)
where,
Interest cost refers to the interest paid on the borrowed amount, and
Tax rate represents the income tax rate that the company must pay.
In this case, the interest cost is 8 percent of $500,000, which is $40,000. The tax rate is 40 percent.
To calculate the actual net-of-tax interest cost:
Actual net-of-tax interest cost = $40,000 * (1 - 0.40)
To find out the effective interest rate, divide the actual net-of-tax interest cost by the borrowed amount:
Effective interest rate = Actual net-of-tax interest cost / Borrowed amount
a. Actual net-of-tax interest cost:
Actual net-of-tax interest cost = $40,000 * (1 - 0.40)
= $40,000 * 0.60
= $24,000
Therefore, the actual net-of-tax interest cost incurred by the company is $24,000.
b. Effective interest rate:
Effective interest rate = Actual net-of-tax interest cost / Borrowed amount
= $24,000 / $500,000
= 0.048 or 4.8%
Thus, the effective interest rate paid by the company is 4.8%.
To calculate the actual net-of-tax interest cost, follow these steps:
a.
1. Calculate the income tax amount: $500,000 * 8% = $40,000
2. Calculate the actual net interest cost by subtracting the income tax amount from the interest payment: $40,000 * (1 - 40%) = $24,000
The actual net-of-tax interest cost for the company is $24,000.
b.
To calculate the effective interest rate, divide the actual net interest cost by the amount borrowed and multiply by 100 to get the percentage:
Effective interest rate = ($24,000 / $500,000) * 100 = 4.8%
Therefore, the effective interest rate paid by the company is 4.8%.