Question

Shanken Corp. issued a 30-year, 6.2 percent semiannual bond 7 years ago. The bond currently sells for 108 percent of its face value. The company’s tax rate is 35 percent. (Assume that the face value of one coupon bond is $1,000.) a. What is the pretax cost of debt? b. What is the aftertax cost of debt? c. Which is more relevant, the pretax or the aftertax cost of debt? Why?

Answer 1

The pretax cost of debt is 5.74% and the aftertax cost of debt is 3.73%. The aftertax cost of debt is more relevant because it considers the tax savings from the interest expense.

Step-by-step explanation:

a. The pretax cost of debt can be calculated using the formula:

Pretax Cost of Debt = (Coupon Rate × Face Value) ÷ Bond Price

In this case, the coupon rate is 6.2% (or 0.062), the face value is $1,000, and the bond is selling for 108% of its face value. So the bond price is $1,080. Plugging these values into the formula, we get:

Pretax Cost of Debt = (0.062 × $1,000) ÷ $1,080 = 5.74%

b. The aftertax cost of debt can be calculated by multiplying the pretax cost of debt by (1 - Tax Rate). In this case, the tax rate is 35%. So the aftertax cost of debt is:

Aftertax Cost of Debt = 5.74% × (1 - 0.35) = 3.73%

c. The aftertax cost of debt is more relevant because it takes into account the tax savings from the interest expense. By using the aftertax cost of debt, the company can make more accurate financial projections and decisions.