Final answer:
The pretax cost of debt for Jiminy’s Cricket Farm is determined by calculating the yield to maturity on the bond. The aftertax cost of debt is then calculated by adjusting the pretax cost by the company's tax rate of 22 percent. The aftertax cost of debt is more relevant for the company, as it reflects the actual cost after tax benefits.
Step-by-step explanation:
To determine the pretax cost of debt for Jiminy’s Cricket Farm's bond, we need to calculate the yield to maturity (YTM) on the bond that currently sells for 93 percent of its face value and has a 7 percent coupon rate with semiannual payments. Since the bond was issued 3 years ago and it's a 30-year bond, there are 27 years, or 54 periods, remaining. Using the bond pricing formula and solving for YTM would give us the pretax cost of debt.
For the aftertax cost of debt, we use the formula:
Aftertax Cost of Debt = Pretax Cost of Debt × (1 - Tax Rate)
Governments typically tax the interest income earned by debt holders. Because interest payments on debt are tax-deductible for the issuer, the aftertax cost of debt is lower and more relevant when considering the realistic cost to the company. In this case, with a tax rate of 22 percent, this results in a lower aftertax cost of debt.