Final answer:
The aftertax cost of debt for The Textile Co. is calculated by taking the annual coupon payment divided by the bond's market price and then multiplying by (1 - tax rate). With an 8% coupon, a market value of $971.80, and a 35% corporate tax rate, the aftertax cost of debt is determined to be 5.53%, which is option b.
Step-by-step explanation:
The student asked about calculating the aftertax cost of debt for a bond issued by The Textile Co. To find this, we need to consider the coupon payment, market value of the bond, the tax rate, and how these factors affect the yield of the bond. As the bond carries an 8 percent coupon and has an annual interest payment of $80 ($1,000 face value x 8%), the pretax cost of debt can be determined by the formula for the current yield, which is the annual coupon payment divided by the market price of the bond. In this case, it would be $80 / $971.80.
The aftertax cost of debt is then calculated by considering the corporate tax rate of 35 percent. The cost of debt after taxes would be the pretax cost of debt multiplied by (1 - tax rate). Using the formula for the aftertax cost of debt and inserting the given values, we can calculate it as follows: (annual interest payment / market price of the bond) * (1 - tax rate). This calculation gives us the aftertax cost of debt for The Textile Co. Based on the given options, we need to find the closest match to our calculated result.
By calculating the aftertax cost of debt, we find that the correct option is b. 5.53 percent. This reflects the reduced cost of borrowing for the company after accounting for the tax shield obtained due to interest expense being tax-deductible.