Final answer:
The before-tax component of Oberon, Inc.'s debt is the yield to maturity (YTM) on their bond issue, which is not necessarily the same as the bond's coupon rate due to changes in market interest rates affecting the bond's market price.
Step-by-step explanation:
To calculate Oberon, Inc.'s before-tax component of debt, we look at the yield to maturity (YTM) on their bond issue. Since the bond is selling for 95 percent of its face value, we know the market price is less than the face value because the market interest rates are likely higher than the bond's coupon rate. Oberon's bond has a $20 million face value and sells at 95%, so the market value of the bonds is $19 million (95% of $20 million).
The annual coupon payment can be found by multiplying the face value by the coupon rate: $20 million * 8.20% = $1.64 million. To find the YTM, which is the before-tax cost of debt, we must solve for the interest rate that equates the present value of the bond's future cash flows (the annual coupon payments and the repayment of face value at maturity) to its current selling price. This is done using financial calculators or software designed for such financial assessments, but the basic concept involves discounting these future cash flows back to their present value using the current market interest rates.
Additionally, it's crucial to recognize that the before-tax cost of debt is not the coupon rate of 8.20%, but rather the yield that equates the bond's cash flows with its present market price. When market interest rates rise, the value of existing bonds tends to fall, as new bonds might be issued with higher coupon rates. Similar logic applies when the market rates fall, making previous higher-rate bonds more valuable.
To summarize, Oberon's before-tax component of debt will be calculated by determining the yield to maturity based on the current market price of the bond ($19 million) and the future cash flows from the bond (annual coupon payments and the face value at maturity).