Question

2. An overview of a firm's cost of debt

Thebefore-tax cost of debt   is the interest rate that a firm pays on any new debt financing.

Perpetualcold Refrigeration Company (PRC) can borrow funds at an interest rate of 12.50% for a period of seven years. Its marginal federal-plus-state tax rate is 30%. PRC’s after-tax cost of debt is     (rounded to two decimal places).

At the present time, Perpetualcold Refrigeration Company (PRC) has 5-year noncallable bonds with a face value of $1,000 that are outstanding. These bonds have a current market price of $1,050.76 per bond, carry a coupon rate of 10%, and distribute annual coupon payments. The company incurs a federal-plus-state tax rate of 30%. If PRC wants to issue new debt, what would be a reasonable estimate for its after-tax cost of debt (rounded to two decimal places)? (Note: Round your YTM rate to two decimal place.)

6.09%

4.87%

5.48%

7.31%

Answer 1

PRC can borrow fund @	12.50%
Tax rate	30%
Post Tax cost of debt is =12.5%*(1-30%)=	8.75%

We need to find the YTM of the bond to decide the post tax cost for new debt
YTM = [Annual interest +(Face value-market price)/n]/(Face value +2*market price)/3
Face value of current bodn	$                    1,000.00
Current Market price=	$                    1,050.76
Annual coupon @10%=	$                       100.00
Years to maturity =n=	$                            5.00
YTM =[100+(1000-1050.76)/5]/(1000+2*1050.76)/3
YTM =8.7%
So the Yield to maturity of the bond =8.7%
Post Tax YTM of bond =8.7%*(1-30%)=	6.09%
So the reasonable estimate for the cost of new debt issue
will be 6.09%
So the correct answer is 6.09%