Question

Currently, Warren Industries issued 15-year, $1000 par-value bonds paying annual interest at a 12% coupon rate. As a result of the current interest rate, the bonds would sell for $980 each. The firm is in the 40% tax bracket. Calculate the before-tax cost and after-tax cost of the bond. A. 12.30%, 6.75% B. 12.30%, 7.38% C. 10.30%, 6.38% D. 13.50%, 7.38%\

Answer 1

B. 12.30%, 7.38%

Step-by-step explanation:

Cost of debt - the return that a company provides to its debt-holders and creditors

`PV = CF [{(1)/(r) - (1)/(r(1 + r)^(n) ) ] + (FV)/((1 + r)^(n) )`

PV = present value = current value of future cash flow

FV = future value

CF = cash flow

R = payment

r = rate of interest

n = number of payments

Cash flows from the firm’s point of view over the maturity of the bond

`t_(0)` = 980

`t_(0) - t_(15)` = - 120

`t_(15)` = - 1000

Before Tax

`PV = CF [{(1)/(r) - (1)/(r(1 + r)^(n) ) ] + (FV)/((1 + r)^(n) )`

Net proceeds =
`N_(d) = 980`

Cash Flows = CF = - 120

n = 15

FV = - 1000

r = 12.30%

After Tax

After-Tax Cost of Debt = Before-Tax Cost of Debt × (1 – Tax Rate)

`t_(c) =` 40%

`r_(d) = r (1 - t_(c))`

= 12.30 (1 - 0.4)

= 7.38%