Question

Jiminy’s Cricket Farm issued a 30-year, 7 percent semiannual bond 3 years ago. The bond currently sells for 93 percent of its face value. The company’s tax rate is 22 percent.
What is the pretax cost of debt?
What is the aftertax cost of debt?
Which is more relevant, the pretax or the aftertax cost of debt? Why?

Answer 1

K = Nx2

Bond Price =∑ [(Semi Annual Coupon)/(1 + YTM/2)^k]     +   Par value/(1 + YTM/2)^Nx2

k=1

K =27x2

93 =∑ [(7*100/200)/(1 + YTM/200)^k]     +   100/(1 + YTM/200)^27x2

k=1

yTM = 7.614% = pretax cost of debt

after tax cost of debt = YTM*(1-tax rate) = 7.614*(1-0.22)

=5.94%

After tax cost debt is more important because debt issuers get tax shield on interest payment of debt, hence interest paid is reduced by the tax shield