Question

Jiminy's Cricket Farm issued a bond with 20 years to maturity and a semiannual coupon rate of 7 percent 5 years ago. The bond currently sells for 94 percent of its face value. The company's tax rate is 24 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.) Pretax cost of debt Aftertax cost of debt b. Af c. Which is more relevant, the pretax or the aftertax cost of debt? Aftertax cost of debt O Pretax cost of debt

Answer 1

	Par/Face value	1000
	Annual Coupon rate	0.14
	Annual coupon	140
	semi-annual coupon	70
	Present Value = Future value/[(1+(r/m))^mt]
	r is the interest rate
	m is the compounding period that is 2
	mt is the time period.
	price of the bond = sum of present values of future cash flows
	price of the bond = 940
	Use excel to find r
	r/2	0.0751	r	0.1502
	mt	1	2	3	4	5	6	30
	future cash flow	70	70	70	70	70	70	1070
	present value	65.11022	60.56201	56.33152	52.39654	48.73643	45.332	121.8759
	sum of present values	939.83
	The yield to maturity on the bonds is .1502 or 15.02%.
a)	Pretax cost of debt = 15.02%
	Aftertax cost of debt = Pretax cost of debt*(1-tc)
	where tc is the company's tax rate.
	Aftertax cost of debt = .1502*(1-.24)
	Aftertax cost of debt = .114152
b)	Aftertax cost of debt = 11.41%
	Weighted average cost of capital (WACC) = [(S/S+B)*Rs + (B/S+B)*Rb(1-tc)]
		S = equity, B = debt, Rs = Cost of equity, Rb = cost of debt,
		tc = corporations tax rate
c)	The Aftertax cost of debt is more relevant because it is used to calculate
	the weighted average cost of capital (WACC).