I got this question right using only an educated guess. (Debt financing's number one advantage is its interest is deductible for tax purposes.)
Neither did I understand the call of the question nor did I understand the logic of the three incorrect choices.
Can someone please provide a simpler explanation?
Thanks.
CPA-03425
If Brewer Corporation's bonds are currently yielding 8 percent in the marketplace, why would the firm's cost of debt be lower?
a.
There is a mixture of old and new debt.
b.
Market interest rates have increased.
c.
Additional debt can be issued more cheaply that the original debt.
d.
Interest is deductible for tax purposes.
Explanation
Choice “d” is correct. Because interest expense is a tax deduction, the cost to Brewer is lower than the market yield rate on debt.
Choice “b” is incorrect. If market interest rates increase, then Brewer's bonds would have to be offered at a discount to stay competitive with the market. This discount would increase (not lower) Brewer's cost of debt.
Choice “c” is incorrect. Issuance of cheaper additional debt will lower future cost of debt, but have no impact on current cost of debt.
Choice “a” is incorrect. Presumably, the 8% yield already includes new and old debt.
.
