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

Question

BlackTom AI · Accepted Answer

To tackle the question, I’ll evaluate how each scenario would affect the aftertax cost of debt, which is typically calculated as after-tax cost = pretax cost of debt × (1 − tax rate).
Option 1: decrease in the company's tax rate. If the tax rate falls, (1 − tax rate) rises, and with a given pretax debt cost, the product increases. Consequently, the aftertax cost of debt goes up. This is a direct, mechanical consequence of a lower tax shield.
Option 2: increase in the credit rating of the company's bonds. A higher credit rating typically lowers the yield lenders require, reducing the pretax cost of debt. Since the aftertax cost is this reduced pretax cost times (1 − tax rate), the aftertax cost would decrease, not increase.
Option 3: increase in the company's beta. Beta measures equity risk and expected return on equity; it does not directly raise the contractual interest rate on debt in a straightforward way. While a higher beta can influence overall cost of capital, the aftertax cost of debt is driven mainly by the debt’s coupon rate and the tax shield, not by beta. Therefore this would not directly cause the aftertax cost of debt to increase.
Option 4: decrease in the market rate of interest. A lower market rate of interest reduces the cost lenders charge for new debt, lowering the pretax cost of debt. With the tax shield intact, the aftertax cost would also decrease, not increase.
Option 5: decrease in the company's debt-equity ratio. Reducing leverage can improve credit risk and potentially lower borrowing costs in the long run, so the pretax cost of debt could fall or stay the same rather than rise. Thus the aftertax cost would not be expected to increase as a result of a lower debt-equity ratio.
Overall, among the options, only a decrease in the tax rate directly raises the aftertax cost of debt, while the others tend to reduce it or have an indirect effect that wouldn’t increase it.

BUSFIN 3220 AU2025 (2910) Exam 3 - Requires Respondus LockDown Browser

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

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