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%. Since the company pays taxes at a 35% marginal rate, their tax savings would be 35% x 11%, which equals 3.9%. Therefore, if they issue new bonds that provide a similar yield to maturity as their existing ones (14%), then their after-tax cost of debt would be 14%-3.9% = 10.1%.

The after-tax cost of debt can be used by companies when evaluating potential capital projects or investments in order to determine which option has the higher expected return on investment given its specific tax situation and borrowing costs associated with financing that project or investment opportunity. Companies can also use it in combination with other factors such as liquidity preferences or risk tolerance levels when making decisions regarding long term financial planning.

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. Finally, government entities often set target benchmarks for corporate borrowing rates in order to incentivize businesses towards investing in more capital intensive projects that help stimulate economic growth within an area without creating additional strain on public resources due excessive leverage incurred through high levels of borrowing.