Question

If a 10-year, 8 percent coupon, $1,000 par value corporate bond is selling at $1,150 (assuming tax-deductibility of interest payments with a marginal tax rate of 40 percent), then its annual opproximate after-tax cost of debt is. Select one: a. 6 percent. b. 11.5 percent. c. 3.6 percent d. 8 percent.

Answer 1

The approximate after-tax cost of debt for the bond is 4 percent, taking into account the tax-deductibility of the interest payments and the bond's selling price.

Step-by-step explanation:

The question asks to calculate the approximate after-tax cost of debt for a corporate bond. To find the after-tax cost of debt, we need to consider the annual interest payment, the price of the bond, and the tax rate. The bond has an 8 percent coupon rate on a $1,000 par value, equating to an annual interest payment of $80. However, since interest payments are tax-deductible, the effective interest cost is reduced by the tax savings. The marginal tax rate is 40 percent, so the after-tax interest payment is $80 × (1 - 0.40) = $48.

Now, we need to consider the return that the investor requires, given the current price of the bond, which is $1,150. The return on investment can be calculated as the after-tax interest payment divided by the current bond price. Therefore, the approximate after-tax cost of debt is $48 / $1,150 = 0.0417 or 4.17 percent. Since this is an annual cost, we annualize it to get the nearest choice, which is 4 percent, corresponding to option 'a' in the question.