Question

Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, Styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below. Assets Current assets $ 38,000,000 Net plant, property, and equipment 101,000,000 Total assets $139,000,000 Liabilities and Equity Accounts payable $ 10,000,000 Accruals 9,000,000 Current liabilities $ 19,000,000 Long-term debt (40,000 bonds, $1,000 par value) 40,000,000 Total liabilities $ 59,000,000 Common stock (10,000,000 shares) 30,000,000 Retained earnings 50,000,000 Total shareholders' equity 80,000,000 Total liabilities and shareholders' equity $139,000,000 Market value of CGT’s stock = $15.25 per share CGT has $1,000 par value,20-year,7.25% coupon bonds with semiannual payments, selling for $875.00. CGT’s stock beta =1.25 6-month Treasury bill yield =3.50% 20-year Treasury bond yield =5.50%. Required return on S&P 500=11.50% The firm's tax rate is 40%. What is the best estimate of CGT’s after-tax cost of debt?

Answer 1

5.14%

Step-by-step explanation:

Determining the pretax cost of debt is the first to do prior to ascertaining after tax cost of debt.

Pretax cost of debt can be computed using the rate formula in excel.

=rate(nper,pmt,-pv,fv)

nper is the number of times the bond would coupon interest,hence paying coupon every six months for 20 years means 40 coupon payments

pmt is the semiannual coupon bondholders would received from the bond i.e $1000*7.25%*6/12=$36.25

pv is the current market price at $875

fv is the face value of $1000

=rate(40,36.25,-875,1000)=4.28% semiannually

=4.28% *2=8.56% annually

after tax cost of debt=8.56%*(1-t),where t is the tax rate of 40% or 0.40

after tax cost of debt=8.56%*(1-0.4)=5.14%