Question

Cost of Borrowing Comey Products has decided to acquire some new equipment having a $290,000 purchase price. The equipment will last 4 years and is in the MACRS 3-year class. (The depreciation rates for Year 1 through Year 4 are equal to 0.3333, 0.4445, 0.1481, and 0.0741.) The firm can borrow at a 5% rate and pays a 25% federal-plus-state tax rate. Comey is considering leasing the property but wishes to know the cost of borrowing that it should use when comparing purchasing to leasing and has hired you to answer this question. What is the correct answer to Comey's question? (Hint: Use the shortcut method to find the after tax cost of the loan payments.) Do not found intermediate calculations. Round your answer to the nearest dollar 3.75 ®

Answer 1

Cost of borrowing is the interest paid on the money borrowed. Money borrowed will be $290,000 which is the purchase price of the machine. Interest paid on loan is tax-deductible. so it will reduce cost of borrowing and we need to use after-tax cost of debt for interest calculations.

After-tax cost of debt = cost of debt before tax*(1-tax rate) = 5%*(1-0.25) = 5%*0.75 = 3.75%

Cost of borrowing = loan amount*After-tax cost of debt*loan period = $290,000*3.75%*4 = $43,500