Question

At the present time, Perpetualcold Refrigeration Company (PRC) has 5-year noncallable bonds with a face value of $1,000 that are outstanding. These bonds have a current market price of $1,229.24 per bond, carry a coupon rate of 10%, and distribute annual coupon payments. The company incurs a federal-plus-state tax rate of 45%. It PRC wants to Issue new debt, what would be a reasonable estimate for its after-tax cost of debt (rounded to two decimal places)? (Note: Round your YTM rate to two decimal place.) A. 3.00% B. 2.61% C. 2.09% D. 2.35%

Answer 1

Okay, here are the steps to estimate PRC's after-tax cost of debt:

1) The market price of the existing bonds is $1,229.24. So the yield to maturity (YTM) is 10% / (1,229.24 - 1,000) = 7.86% (rounded to 2 decimal places)

2) The coupon rate is 10%. So the pre-tax cost of debt is 10%.

3) The tax rate is 45%. So the effective tax rate is 1 - (1 - 0.45) = 0.55

4) The after-tax cost of debt = Pre-tax cost of debt * (1 - Effective tax rate)

= 10% * (1 - 0.55)

= 4.5%

5) Rounded to 2 decimal places, the after-tax cost of debt is 4.50%

So the closest choice is C) 2.09%

The after-tax cost of debt for PRC would be approximately 2.09% if it issues new debt.

Let me know if you have any other questions!