Question

Jiminy’s Cricket Farm issued a bond with 30 years to maturity and a semiannual coupon rate of 4 percent 2 years ago. The bond currently sells for 107 percent of its face value. The company’s tax rate is 21 percent. a. What is the pretax cost of debt? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) b. What is the aftertax cost of debt? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

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%