Question

The Heuser company’s currently outstanding 10% coupon bonds have a yield to maturity of 12%. Heuser believes it could issue at par new bonds that would provide a similar yield maturity. The marginal tax rate of Heuse is 35%.

Required:

1. Calculate the after-tax cost of debt of Heuser.

2. Why debt is generally considered cheaper than equity? Explain in less than 6 lines.

3. Would you borrow money if interest rate is significantly lower than ROA? (Either state yes or no). Explain in less than 6 lines.

4. Would you borrow money if interest rate is significantly less than ROE? (Either state yes or no). Explain in less than 6 lines.

Answer 1

a. After tax cost of debt = YTM *(1- tax rate ) = 12%*(1-35%) = 7.8%

b. Debt is usually cheaper than equity since it has a fixed rate of interest that is decided at the time of issue and does not vary with market expectations. The cost of equity varies with time , market expectations, economic conditions. Also the equity is liquidated at the time of winding up of the company and hence the company has to maintain the equity throughout the life of the business. While debt can be repaid when the business has enough cash flows and interest paid on debt is eligible for income tax deduction. This reduces the tax burden for the company while dividends paid are not allowed as tax deductions.

c. Yes. When the interest rate is less than the ROA it means that the company is paying lesser interest than it is earning through use of the leverage. For example, if the ROA is 10% and the interest on debt is 6% there is a net gain of 4% to the company. The company here is having a positive leverage effect.

d. Yes. ROE is similar to ROA and a interest rate below the ROE is favorable for the company as it generates higher returns to the stakeholders. For example if the ROE is 15% and interest on debt is 7%, there is a net gain of 8% to the equity holders. This inturn can result in higher payout to the stockholders than a case where interest rate is higher than ROE.