18.1: What is Debt?

Question 1

How is debt defined?

Answer 1

Debt is a contract between a lender and a borrower that stipulates the terms of repayment of the loan.

Question 2

What is the critical component that makes interest on debt securities deductible for tax purposes?

Answer 2

The interest on debt securities is fully deductible for tax purposes by the borrower and fully taxable for the lender.

Question 3

What are fixed contractual commitments?

Answer 3

Contractual terms that commit the parties involved to adhere to specific requirements.

Question 4

How do debt and equity differ in terms of fixed contractual commitments?

Answer 4

Debt involves fixed contractual commitments such as interest and principal repayments, while equity does not have such fixed commitments.

Question 5

What is the tax implication of interest payments on debt?

Answer 5

Interest payments on debt are tax deductible, reducing the taxable income and thus the tax bill of the firm.

Question 6

Calculate the firm’s net cost for using debt with a 7% interest rate and a 30% corporate tax rate.

Answer 6

After-tax cost of debt (k) = k_d (1 - T)
= 0.07 (1 - 0.30)
= 0.07 × 0.70
= 0.049 or 4.9%

Question 7

What is the formula for the after-tax cost of debt (k)?

Answer 7

k = k_d (1 - T)

Question 8

What three basic tests does the CRA use to ensure that interest on debt is tax deductible?

Answer 8

1. Interest is compensation for the use or retention of money owed to another.
2. Interest must be referable to a principal sum.
3. Interest accrues from day to day.

Question 9

What is the key difference between debt and equity regarding the cost of doing business?

Answer 9

Debt payments are considered a legitimate cost of doing business and are tax deductible,

while equity costs are not deductible and represent returns to the owners of the business.

Question 10

What happens to a firm’s tax bill when it uses debt instead of equity for financing?

Answer 10

The firm’s tax bill is reduced because the interest payments on debt are tax deductible.

Question 11

Concept Review Question - Distinguish debt from equity.

Answer 11

Debt involves fixed contractual commitments and tax-deductible interest payments, while equity involves ownership, sharing in profits, and no fixed contractual payments.

Question 12

Concept Review Question - Explain how to estimate the after-tax cost of debt.

Answer 12

The after-tax cost of debt is calculated using the formula:

k = k_d (1 - T)

where k_d is the before-tax interest cost of the firm’s debt and T is the corporate tax rate.