After-tax cost of debt Personal Finance Problem Bella Wans is interested in buyi
ID: 2788219 • Letter: A
Question
After-tax cost of debt Personal Finance Problem Bella Wans is interested in buying a new motorcycle. She has decided to borrow the money to pay the $30,000 purchase price of the bike. She is in the 30% federal income tax bracket. She can either borrow the money at an interest rate of 5% from the motorcycle dealer, or she could take out a second mortgage on her home. That mortgage would come with an interest rate of 8%. Interest payments on the mortgage would be tax deductible for Bella, but interest payments on the loan from the motorcycle dealer could not be deducted on Bella's federal tax retum. a. Calculate the after-tax cost of borrowing from the motorcycle dealership b. Calculate the after-tax cost of borrowing through a second mortgage on Bella's home c. Which source of borrowing is less costly for Bella? d. Is there any other consideration that Bella ought to think about when deciding which loan to take out to pay for the motorcycle?Explanation / Answer
a.
Interest rate offered by Motorcycle dealer is 5%. Interest charge by dealer is not tax deductibleSo, after tax cost of debt is equal to before tax cost of debt that is 5%.
So, after tax cost of debt remaisn at 5%.
b.
Borrowing through mortgage offer 8% interest rate. and this interest is tax deductible.
So after tax cost of debt = 8% × (1 - 30%)
= 5.60%
After tax cost of debt, borrowing through a second mortgage is 5.60%.
c.
Since, after tax cost of debt is lower for dealer offer. So, he should accept dealer offer and borrow from dealer only.
4.
Other conideration that Bella might be consider before taking loan is mention below:
1. Closing charge offer by dealer and second mortgage.
2. number of time interest rate compounding in a year by both lender.