Question

Bermuda Cruises issues only common stocks and coupon bonds. The firm has a debt-equity ratio of

0.45. The cost of equity is 17.6 percent.
Required:
What is the pre-tax cost of the company debt if weighted average costs of the company is 13.5% and
the firm's tax rate is 35 percent?

Answer 1

The pre-tax cost of debt is 6.75%

Explanation:

In this question, we are interested in calculating the pre-tax cost of the company debt.

To calculate this, we use the mathematical formula below;

Pre-tax cost of debt = (WACC - equity/(value * cost of debt)) / (debt equity ratio/ value * (1-tax rate))

From the question, we identify the parameters in the equation as follows :

WACC is weighted average cost of company = 13.5%

equity = 1

value = equity + debt-equity ratio = 1+ 0.45 = 1.45

Cost of equity = 17.6%

debt-equity ratio = 0.45

Tax rate = 35%

Now, substituting these values into the equation, we have;

Pre-tax cost of debt =

(13.5%(-1/(1.45*17.6%)/(0.45/(1.45*(1-35%))

= 0.0675 or 6.75%