Question

Jiminy’s Cricket Farm issued a 25-year, 6 percent semiannual coupon bond 2 years ago. The bond currently sells for 107 percent of its face value. The company’s tax rate is 21 percent. a. What is the company’s pretax cost of debt? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) b. What is the company’s aftertax cost of debt? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

Step-by-step explanation:

The pretax cost of debt is the YTM of the bond. Using a financial calculator, input the following to calculate annual interest rate; YTM.

note: adjust the time and recurring payment to semiannual basis.

Maturity of the bond ; N = 25*2 = 50

Face value of the bond ; FV = 1,000

Price of the bond; PV = -( 1.07 * 1000) = -1,070

Semi-annual payment; PMT = (6%/2)*1,000 = 30

Compute semiannual interest rate ; CPT I/Y = 2.741%

Convert the semiannual rate to annual rate(YTM) = 2.741% * 2 = 5.482%

Therefore, pretax cost of debt is 5.48%

Since interest paid on debt has tax benefits through interest tax shield, the after tax cost of debt can be calculated. It is basically solved by adjusting the pretax cost of debt to incorporate this tax benefit. The formula is as follows;

Aftertax cost of debt = Pretax cost of debt (1-tax)

Aftertax cost of debt = 0.0548(1-0.21) = 0.0433 or 4.33%