Final answer:
The pre-tax cost of debt is calculated using the bond's current yield, while the after-tax cost of debt also incorporates the tax shield from interest expenses. The after-tax cost of debt is more relevant for valuation and analysis since it reflects the true cost to the company.
Step-by-step explanation:
The cost of debt for Bugsy's Cricket Farm's semi-annual 7% bond, which currently sells for 93% of its face value, can be calculated as follows:
Pre-tax Cost of Debt (A)
To find the pre-tax cost of debt, we need to take into account the current yield of the bond. Since the bond is sold at a discount (93% of the $1000 face value), the annual interest payment of $70 (7% of $1000) is divided by the current price of the bond ($930), and then multiplied by 2, as the bond is semiannual. This gives us the pre-tax cost of debt.
After-tax Cost of Debt (B)
The after-tax cost of debt considers the tax shield realized from the interest expense. Since the tax rate is 35%, the after-tax cost of debt is the pre-tax cost of debt multiplied by (1-0.35).
Relevance of Pre-tax vs. After-tax Cost of Debt (C)
For purposes related to company valuation and investment analysis, the after-tax cost of debt is more relevant because it shows the actual cost borne by the company after benefiting from the tax deductibility of interest expenses.