Question

Currently, Warren Industries issued 15-year, $1000 par-value bonds paying annual interest at a 12% coupon rate. As a result of the current interest rate, the bonds would sell for $980 each. The firm is in the 40% tax bracket. Calculate the before-tax cost and after-tax cost of the bond. A. 12.30%, 6.75% B. 12.30%, 7.38% C. 10.30%, 6.38% D. 13.50%, 7.38%\

Answer 1

B. 12.30%, 7.38%

Explanation:

Cost of debt - the return that a company provides to its debt-holders and creditors

$PV = CF [{\frac{1}{r} - \frac{1}{r(1 + r)^{n} } ] + \frac{FV}{(1 + r)^{n} }$

PV = present value = current value of future cash flow

FV = future value

CF = cash flow

R = payment

r = rate of interest

n = number of payments

Cash flows from the firm’s point of view over the maturity of the bond

$t_{0}$ = 980

$t_{0} - t_{15}$ = - 120

$t_{15}$ = - 1000

Before Tax

$PV = CF [{\frac{1}{r} - \frac{1}{r(1 + r)^{n} } ] + \frac{FV}{(1 + r)^{n} }$

Net proceeds = $N_{d} = 980$

Cash Flows = CF = - 120

n = 15

FV = - 1000

r = 12.30%

After Tax

After-Tax Cost of Debt  = Before-Tax Cost of Debt × (1 – Tax Rate)

$t_{c} =$ 40%

$r_{d} = r (1 - t_{c})$

= 12.30 (1 - 0.4)

= 7.38%