CFA Practice Question
Consider the following characteristics of a firm:
Annual dividend: $1
Debt rate: 12%
Equity floatation cost: 5%
Tax rate: 40%
Preferred stock par value: $100
Stock price: $60
Annual dividend: $1
Debt rate: 12%
Equity floatation cost: 5%
Tax rate: 40%
Preferred stock par value: $100
What is the firm's after-tax cost of debt?
A. 5%
B. 7.2%
C. 12%
Explanation: A firm's after-tax cost of debt may be calculated using the following formula: After-Tax Cost of Debt = Cost of Debt x (1 - Tax Rate). In this case, the after-tax cost of debt = 12% x (1 - 40%) = 12% x 60% = 7.2%.
User Contributed Comments 12
| User | Comment |
|---|---|
| julamo | this question is far below the average level of this mock exam, it's like some fresh air in hell! |
| ontrack | and i thought there's some other formula involved that i dont know so did not select C!! |
| Hope02 | This question scared the hell out of me for nothing. Nevertheless, I took good note as some answers to questions are right to our nose. |
| twotwo | why give the extra information not needed!!! |
| julescruis | I went crazy on this one: I tried to derive the cost of capital using CAPM and DDM. This reminds me to be thourough in the reading of the questions |
| sagania | I couldnt believe it could be that simple... Of course I guessed then, and guesses wrong! |
| scotty21 | I was dominated by this question also franticly trying to figure out how to apply the CAPM without knowing the debt/equity ratio... Must READ the question. Cost of DEBT! |
| JepTang | Intuitively, given the answer choices, one could immediately determine that the answer would be B. 50% of 12% would be 6%, thus A should immediately be scratched out. 12% would not be realistic as cost of debt is tax deductible, this leaves us with B which is a little higher than 6%. |
| Yohan3109 | Just always remeber the real cost of debt after tax rate (1-tx)*debt rate. no need to derivate nothing. read carrefuly the question CFA exam is 240 questions just few of them will invole big calculation... |
| mekc | determine question first, info second, saves time and avoids confusion |
| ColonelCFA | I was trying to figure out how I could make this a WACC questions! |
| farhan92 | good point yohan.. think it is worth taking a step back to understand what the question is asking before going crazy with the calculator. Bringing some eco theory into it the marginal cost of spending 5 minutes on a calculation is far greater than the marginal benefit :) |