CMA Study Group

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• 1.  cost of capital

Posted 11-18-2019 10:01 PM
A recent leveraged buyout was financed with \$50M. This amount comprised partner's equity capital of \$12M, \$20M unsecured debt borrowed at 7% from one bank, and the remainder from another bank at 8.5%. What is the overall after-tax cost of the debt financing if you expect the firm's marginal tax rate to be 33%?
 7.75% 4.96% 5.17% 7.71%

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Syed Yousuf Jamal

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• 2.  RE: cost of capital

Posted 11-19-2019 02:09 AM
5.17%

overall before-tax cost of the debt financing (average cost of financing 38 Million which is 50 million minus 12 Million by equity)  = (20 X 7% +18*8.5%)/ (20+18) = (1.4+1.53)/38 = 7.71%
overall after-tax cost of the debt financing  =  7.71 % X 67% = 5.17%

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Mathew John
Supervisor
Al Maha Petroleum Products Marketing Co SAOG
Not Specified
Oman
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• 3.  RE: cost of capital

Posted 11-19-2019 02:18 AM

5.17%

the question is asking for the after tax cost of debt financing only. The debt financing portion is 38M. The weight is as follows

29M = 53.63% ( 29/38)

18M = 47.37% (18/38)

after tax cost of 29M = 7%x(1-33%)x52.63%= 2.468%

after tax cost of 18M = 8.5%x(1-33%)x47.37%= 2.698%

add the after tax cost of the two debt components will result 5.166%. Rounding off to 5.17%

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Sunil Divakaran
Accountant
DUBAI
United Arab Emirates
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• 4.  RE: cost of capital

Posted 11-19-2019 11:28 AM
Hi dear,

Not sure how you're calculating 29M, please elaborate

Regards,
Zubair

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Analyst
Al Jubail
Saudi Arabia
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• 5.  RE: cost of capital

Posted 11-19-2019 12:51 PM
Sorry, it was a typing mistake. I said the total debt portion is 38M, but instead of 20M, I erroneously put 29.

Sent from my iPhone

• 6.  RE: cost of capital

Posted 11-19-2019 12:23 PM
I believe the answer is 5.17% as follows:

20M @ 7% and 50M – 12M – 20M = 18M @ 8.5%
Weighted average pretax cost of debt = 7(20/38) + 8.5(18/38) = 7.71%
After-tax cost of debt = 7.71% (1-.33) = 5.17%

The part of this MCQ that I am unsure about is the cost of the equity capital. I can only assume
that the word "partner's" equity capital in some way means that the assumed cost of that
equity capital is zero.

• 7.  RE: cost of capital

Posted 09-21-2023 05:36 AM

The question is asking for the cost of the debt / interest after tax, interest on debt reduces our taxes. In simple terms, the actual interest to a company may be lower on an after-tax basis because interest payments are typically tax-deductible.<o:p></o:p>

Cost of the debt / Interest = is an expense and it is deducted from income before we calculate taxes on that income<o:p></o:p>

Cost of equity / Dividend – is not an expense. And it is not tax-deductibles, as we pay-out dividends after paying taxes and after net income.<o:p></o:p>

However, when analyzing financial metrics or making financial decisions, it's common to consider the pre-tax cost of debt as a starting point before factoring in any tax advantages. This is because tax laws and rates can change, and it's important to have a baseline understanding of the cost of debt without relying on specific tax benefits.<o:p></o:p>

So, total debts are 38m and interest on those debt is 2.93m.<o:p></o:p>

Cost of the debt before taxes is 2.93m/38m = 7.710%<o:p></o:p>

So, after tax income % would be 67% (1-tax rate)<o:p></o:p>

Cost of the debt after taxes is 7.710% * 67% (0.0771*0.67) = 5.17%<o:p></o:p>

I hope this should make the concept easy to understand!

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SHAIBAN AHMED HAJI FAQUIH
Accountant
DUBAI
United Arab Emirates
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