# CMA Study Group

View Only
• #### 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%

------------------------------
Syed Yousuf Jamal

------------------------------

• #### 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%

------------------------------
Mathew John
Supervisor
Al Maha Petroleum Products Marketing Co SAOG
Not Specified
Oman
------------------------------

• #### 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%

------------------------------
Sunil Divakaran
Accountant
DUBAI
United Arab Emirates
------------------------------

• #### 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

------------------------------
Analyst
Al Jubail
Saudi Arabia
------------------------------

• #### 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.

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

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.

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.

So, total debts are 38m and interest on those debt is 2.93m.

Cost of the debt before taxes is 2.93m/38m = 7.710%

So, after tax income % would be 67% (1-tax rate)

Cost of the debt after taxes is 7.710% * 67% (0.0771*0.67) = 5.17%

I hope this should make the concept easy to understand!

------------------------------
SHAIBAN AHMED HAJI FAQUIH
Accountant
DUBAI
United Arab Emirates
------------------------------