After-tax cost of debt Bella Wans is interested in buying a new motorcycle. She has decided to borrow money to pay the $25,000 purchase price of the bike. She is in the 25% federal income tax bracket. She can either borrow the money at an interest rate of 5% from the motorcycle dealer, or she could take out a second mortgage on her home. That mortgage would come with an interest rate of 6%. Interest payments on the mortgage would be tax deductible for Bella, but interest payments on the loan from the motorcycle dealer could not be deducted on Bella's federal tax return.

a. Calculate the after-tax cost of borrowing from the motorcycle dealership.

b. Calculate the after-tax cost of borrowing through a second mortgage on Bella's home.

c. Which source of borrowing is less costly for Bella?

d. Is there any other consideration that Bella ought to think about when deciding which loan to take out to pay for the motorcycle?

Question

Haylie Riley

Business

17 September, 07:36

After-tax cost of debt Bella Wans is interested in buying a new motorcycle. She has decided to borrow money to pay the $25,000 purchase price of the bike. She is in the 25% federal income tax bracket. She can either borrow the money at an interest rate of 5% from the motorcycle dealer, or she could take out a second mortgage on her home. That mortgage would come with an interest rate of 6%. Interest payments on the mortgage would be tax deductible for Bella, but interest payments on the loan from the motorcycle dealer could not be deducted on Bella's federal tax return.

a. Calculate the after-tax cost of borrowing from the motorcycle dealership.

b. Calculate the after-tax cost of borrowing through a second mortgage on Bella's home.

c. Which source of borrowing is less costly for Bella?

d. Is there any other consideration that Bella ought to think about when deciding which loan to take out to pay for the motorcycle?

+1

Answers (1)

Know the Answer?

Nash Stevenson · Answer 1

a. 5%

b. 4.5%

c. Second mortage

d. Yes. is she in condition to pay?

Explanation:

a. Since Bella can't deduct the interest payments on the loan taken from the dealer in her tax return, after-tax cost of borrowing will be the same as stated interest rate. So, the after-tax cost of borrowing from the dealership will be 5%.

b. After-tax cost of borrowing for second mortgage = 6% x (1-25%) = 4.5%

c. It is evident from the above two answers that second mortgage loan is less costly for Bella.

d. Yes. Bella must consider the level of her first mortgage loan. If Bella opts for the second mortgage loan and if she is unable to pay her mortgage, she may lose her home due to this loan. So, she must check first, if she is able to pay the loan on time.