Question

Recently the corporate tax law in the U.S. changed so that firms that previously faced a marginal tax rate of close to 40% now pay tax at a flat rate of 21%. Holding everything else constant, this reduction in the tax rate faced by corporations ________.

Answer 1

Answer:

a.) increased the after-tax cost of debt

Explanation:

Missing options are:

a.) increased the after-tax cost of debt

b.) did not change the after-tax cost of debt

c.) increased the value of the deduction for interest expense

d.) decreased the after-tax cost of debt

The after tax cost of debt is calculated by multiplying the debt's principal x interest rate x (1 - tax rate). If the tax rate decreases, the after tax cost of debt increases. e.g.

$1,000 owed at 6%, when tax rate was 40% ⇒ after tax cost of debt = $1,000 x 6% x (1 - 40%) = $36 or 3.6%

now, $1,000 owed at 6%, when tax rate is 21% ⇒ after tax cost of debt = $1,000 x 6% x (1 - 21%) = $47.40 or 4.74%