Question

great lakes packing has two bond issues outstanding. the first issue has a coupon rate of 8 percent, matures in 6 years, has a total face value of $5 million, and is quoted at 101.2 percent of face value. the second issue has a 7.5 percent coupon, matures in 13 years, has a total face value of $18 million, and is quoted at 99 percent of face value. both bonds pay interest semiannually. what is the firm's weighted average after-tax cost of debt if the tax rate is 34 percent?

Answer 1

The weighted average after-tax cost of debt for Great Lakes Packing is 5.204%.

Step-by-step explanation:

The correct answer is option B.

The weighted average after-tax cost of debt can be calculated by taking the average of the after-tax cost of each bond, weighted by the proportion of each bond's total face value.

For the first bond:

1. Coupon rate = 8%
2. Maturity = 6 years
3. Face value = $5 million
4. Quoted at 101.2% of face value

The after-tax cost of debt for the first bond can be calculated as:

(Coupon rate x Face value x (1 - Tax rate)) / (Quoted price x Face value) = (8% x $5 million x (1 - 34%)) / (101.2% x $5 million) = 0.0668 or 6.68%

For the second bond:

1. Coupon rate = 7.5%
2. Maturity = 13 years
3. Face value = $18 million
4. Quoted at 99% of face value

The after-tax cost of debt for the second bond can be calculated as:

(Coupon rate x Face value x (1 - Tax rate)) / (Quoted price x Face value) = (7.5% x $18 million x (1 - 34%)) / (99% x $18 million) = 0.0496 or 4.96%

The weighted average after-tax cost of debt can be calculated as:

(Total after-tax cost of debt for first bond x Proportion of first bond's face value) + (Total after-tax cost of debt for second bond x Proportion of second bond's face value) = (0.0668 x ($5 million / ($5 million + $18 million))) + (0.0496 x ($18 million / ($5 million + $18 million))) = 0.05204 or 5.204%