LL Incorporated’s currently outstanding 11% coupon bonds have a yield to maturity of 14%. LL believes it could issue new bonds at par that would provide a similar yield to maturity. If its marginal tax rate is 35%, what is LL’s after-tax cost of debt?

Problem 9-2 After-tax Cost of Debt

LL Incorporated’s after-tax cost of debt is 10.1% (14%-3.9%). To calculate the after-tax cost of debt, we need to subtract LL Incorporated’s tax savings from its current pre-tax yield to maturity. The current coupon rate for LL’s 11% bonds is equal to the pre-tax yield to maturity, which is 14%. Their tax savings are 35% x 11 (11%), which is 3.9%, since the company has a marginal rate of 35%. They could also issue bonds of similar maturity yield as the existing (14%), and their after-tax debt cost would then be 14%-3.9%=10.1%

When evaluating possible capital projects and investments, companies can calculate the after-tax debt cost. It is used to help determine which investment option will yield the best return given its tax situation. When making long-term financial planning decisions, companies can use this information in conjunction with other factors like liquidity preferences and risk tolerance levels.

Additionally, this information can prove useful for investors interested in evaluating certain stocks since knowing a company’s estimated after-tax cost of debt provides insight into how much interest payments might impact future earnings and cash flows – thereby influencing investor expectations about performance over time. To encourage investment in high-capital projects and stimulate growth, the government sets benchmarks in corporate borrowing rates.

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