Question

Another company plans to issue 20-year bonds with a face value of $1,000 and an annual coupon rate of 10%. The market price of similar bonds is $1,098. Flotation costs are estimated to be 5% for each bond. If interest payments are made annually, and the company’s marginal tax rate is 34%, what is the after-tax cost of debt?.

Answer 1

The after-tax cost of debt is 6.28%.  Subtract a company's effective tax rate from one and multiply the difference by its cost of debt to calculate its after-tax cost of debt.

What is After-tax cost?

• After-tax cost denotes the actual costs less an amount equal to the combined federal and state income tax savings relating to the deductibility of said costs for federal and state tax purposes in the year in which such costs are incurred.

• WACC represents a company's average after-tax cost of capital from all sources, including common stock, preferred stock, bonds, and other forms of debt.

• WACC is the average interest rate that a company anticipates paying to finance its assets. The pre-tax cost of debt must be tax-affected because interest is tax-deductible, effectively creating a "tax shield" that is, interest expense reduces a company's taxable income (earnings before taxes, or EBT).

Therefore,

The after-tax cost of debt is 6.28%.

FV = -$1,000

PMT = -$100

N = 20 years

PV = $1,098 before including flotation costs; $1,098×(1-.05) = $1,043.10 after including flotation costs.

Compute I/Y = 9.511%

After-tax cost of debt = 9.511%×(1-.34) = 6.28%

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