A firm's aftertax cost of debt will increase if there is a(n):

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BlackTom AI · Accepted Answer

Reframing the question helps focus on what drives aftertax debt costs in a typical corporate finance setting.
Option 1: 'decrease in the company's debt-equity ratio.' A lower D/E ratio often reflects less leverage, which can influence the cost of debt indirectly via credit quality, but it does not inherently raise the aftertax cost of debt. In fact, with less leverage, a firm might enjoy a higher aftertax cost of debt only if debt issuances become more expensive for some unrelated reason; otherwise, this change is not a direct mechanism that increases aftertax debt cost. So this option is not a guaranteed cause of higher aftertax debt cost.
Option 2: 'increase in the credit rating of the company's bonds.' An improved credit rating typically lowers the cost of debt because lenders demand less return for lower risk. Therefore, this would reduce, not increase, the aftertax cost of debt. This option is clearly contrary to how debt pricing works.
Option 3: 'decrease in the company's tax rate.' The aftertax cost of debt is calculated as pretax cost of debt times (1 minus the tax rate): r_d(1 - T). When the tax rate falls, the tax shield from debt diminishes, making the aftertax cost of debt higher. This is the direct, textbook mechanism by which aftertax debt cost rises.
Option 4: 'increase in the company's beta.' Beta measures systematic risk and influences the cost of equity, not the cost of debt. Unless there’s an unusual cross-channel effect, debt costs depend on interest rates and credit risk, not beta. Thus this change does not inherently raise the aftertax cost of debt.
Option 5: 'decrease in the market rate of interest.' Lower market interest rates reduce the cost of debt in the first place, so the aftertax cost would fall, not rise. This option would move the cost in the opposite direction.
In summary, the only option that directly leads to a higher aftertax cost of debt is a decrease in the tax rate, since it reduces the tax shield that debt provides to the firm.

BUSFIN 3220 AU2025 (2110) Exam 3 - Requires Respondus LockDown Browser

A firm's aftertax cost of debt will increase if there is a(n):

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