Question

The aftertax cost of debt:

Answer 1

Answer:

The full options for this answer are:

A. varies inversely to changes in market interest rates.

B. will generally exceed the cost of equity if the relevant tax rate is zero.

C. will generally equal the cost of preferred if the tax rate is zero.

D. is unaffected by changes in the market rate of interest.

E. has a greater effect on a firm's cost of capital when the debt-equity ratio increases.

The correct answer is E. has a greater effect on a firm's cost of capital when the debt-equity ratio increases.

Explanation:

The cost of debt refers to the effective rate that a company pays for its current debt. In most cases, this phrase refers to the after-tax cost of debt, but it also refers to the cost of a company's debt before taxes are taken into account. The difference in the cost of debt before and after taxes lies in the fact that interest expenses are deductible.

The cost of debt is a part of a company's capital structure, which also includes the cost of capital. A company can use various bonds, loans and other forms of debt, so this measure is useful to give an idea of the overall rate the company pays for its debt. The measure can also give investors an idea of the company's risk compared to others, because riskier companies generally have a higher cost of debt.