Answer:
Explanation:
The pretax cost of debt is the YTM of the bond and the aftertax cost of debt is tax-adjusted. You can use a financial calculator and key in the following inputs.
note: adjust the recurring payment and time to semiannual basis.
Maturity of the bond as of today; N = 28*2 = 56
Price of the bond; PV = -( 1.07 * 1000) = -1,070
Face value of the bond ; FV = 1,000
Semi-annual payment; PMT = (4%/2)*1,000 = 20
Compute semiannual interest rate ; CPT I/Y = 1.801%
Next, convert the semiannual rate to annual rate(YTM) = 1.801% * 2 = 3.60%
Therefore, pretax cost of debt is 3.60%
Interest paid on borrowed money (debt) has tax benefits through interest tax shield. Based on this, the after tax cost of debt can be calculated. You can solve it by adjusting the pretax cost of debt to incorporate this tax benefit. The formula is as follows;
Aftertax cost of debt = Pretax cost of debt (1-tax)
Aftertax cost of debt = 0.0360(1-0.21) = 0.02844 or 2.84%
