Question

To calculate the after-tax cost of debt, multiply the before-tax cost of debt by ________________

Answer 1

Answer:

To calculate the after-tax cost of debt, multiply the before-tax cost of debt by (1 - tax rate).

Water and Power Company (WPC) can borrow funds at an interest rate of 10.20% for a period of four years. Its marginal federal-plus-state tax rate is 45%. WPC's after-tax cost of debt is = 10.20% x (1 - 45%) = 5.61%.

At the present time, Water and Power Company (WPC) has 15-year noncallable bonds with a face value of $1,000 that are outstanding. These bonds have a current market price of $1,329.55 per bond, carry a coupon rate of 12%, and distribute annual coupon payments. The company incurs a federal-plus-state tax rate of 45%. If WPC wants to issue new debt, what would be a reasonable estimate for its after-tax cost of debt (rounded to two decimal places)?

B. 4.47%

pre-tax cost of debt = bond's yield to maturity

approximate YTM = {120 + [(1,000 - 1,329.55)/15] /  [(1,000 + 1,329.55)/2] = 98.03 / 1,164.775 = 0.08416 = 8.416%

approximate after tax cost of debt = 8.4% x (1 - 45%) = 4.62 = 4.62

since I used the approximate yield to maturity, my answer is not exact. That is why I have to look for the closest available option.