Question

Jiminy's Cricket Farm issued a 30-year, 7.8 percent semiannual bond 5 years ago. The bond currently sells for 92 percent of its face value. The company’s tax rate is 40 percent. Required: (a) What is the pretax cost of debt? (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).) Pretax cost of debt % (b) What is the aftertax cost of debt? (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).) Aftertax cost of debt % (c) Which is more relevant, the pretax or the aftertax cost of debt?

Answer 1

Answer:

Pretax cost of debt is 8.58%

after tax cost of debt is 5.15%

After tax cost of debt of 5.15% is more relevant because that reflects the true cost of debt bearing in mind that debt has a tax advantage(tax shield).

Explanation:

The pretax cost of debt can be computed using the rate formula in excel as follows:

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

nper is the number of coupons the bond would pay i.e 25years(years to maturity)*2=50

pmt is the semiannual coupon interest=$1000*7.8%*6/12=$39

pv is the present price of the bond=$1000*92%=$920

fv is the face value of $1000

=rate(50,39,-920,1000)=4.29%

Annual yield=4.29%*2=8.58%

after tax cost of debt=pretax cost of debt*(1-t)

t is the tax rate of 40%

after tax cost of debt=8.58%*(1-0.4)=5.15%