Which of the following statements regarding the aftertax cost of debt is accurate?

Question

BlackTom AI · Accepted Answer

Question restatement: The prompt asks which statement about the after-tax cost of debt is accurate, given five options.

Option 1: 'It will generally equal the cost of preferred stock if the tax rate is zero.' If the tax rate were zero, the after-tax cost of debt would simply be the pretax cost of debt, not necessarily equal to the cost of preferred stock. The cost of debt and the cost of preferred stock are determined by different market and contractual factors (interest versus dividends); there is no general reason they must be equal. Therefore this statement is inaccurate.

Option 2: 'It varies inversely with changes in market interest rates.' If market interest rates rise, the cost of new debt generally rises, not falls, so the after-tax cost of debt tends to move in the same direction as market rates (though the tax shield is involved). Saying it varies inversely with rates is incorrect because the relationship is typically direct: higher market rates lead to higher pretax debt costs, and thus higher after-tax costs when tax rates are unchanged. This option is incorrect.

Option 3: 'It will generally exceed the cost of equity if the relevant tax rate is zero.' When the tax rate is zero, the after-tax cost of debt reduces to the pretax cost of debt. In most cases, the cost of debt (even pretax) is less than the cost of equity, due to debt being less risky and bearing tax advantages (though without the tax shield, the comparison can vary, but the usual finance principle is that debt is cheaper than equity). Thus this statement is not generally true and is incorrect.

Option 4: 'It is highly dependent upon a company's tax rate.' This is the central, correct point: the after-tax cost of debt is rd × (1 − T), where rd is the pretax cost of debt and T is the tax rate. The tax shield provided by debt lowers the effective cost of debt, so changes in the tax rate significantly affect the after-tax cost. This option is accurate.

Option 5: 'It is unaffected by changes in the market rate of interest.' In reality, the after-tax cost of debt responds to changes in market interest rates because new debt costs reflect current rates, albeit adjusted by taxes. Therefore this statement is false.

Overall assessment: Among the options, only Option 4 correctly identifies that the after-tax cost of debt is highly dependent on the company's tax rate, with the other statements mischaracterizing the relationships among tax rate, market rates, and costs of debt versus equity.

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

Which of the following statements regarding the aftertax cost of debt is accurate?

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