Question

1 Q1. (25 marks) The Royal Inc. is currently in the business of making kitchen cabinets. It has $400,000 in outstanding bonds with a coupon rate of 8% and a yield-to-maturity of 7.5%. The company is seeking additional financing so it can start a new venture, which involves the sales and installation of patio rooms, including spas and hot tubs. Its biggest competitor, who specializes solely in patio rooms, has $600,000 in outstanding bonds with a 9% coupon rate and an 11% yield-to-maturity. Royal's marginal tax rate is 35% and the competitor's marginal tax rate is 34%. What after-tax rate cost of debt should the Royal Inc. use in its WACC calculation? Which source of capital structure is likely to provide more tax-related benefit? (Show detailed calculations)

Answer 1

Ansuser- Summarized the information and data given in the question; The Royal Inc., is custently in the business of making Kitchen ---- Royal Incos Competitcos Bond value = $4,00,000 Bendvalue = $6,00,000 (fu) (f/2). Coupon catec, = 8.61 • Coupon cate Gz = 90% •Yield to 7,54% Yield to maturity maturity = Ill. . Takk satet, - 35°/ · Tax rate ta = 3401 Cost of debt =? Cost of debt-? PU= C+ FV, •PV₂= Cat Fiz 1+y, = 400,000 +8. 600000+7 Hot5 ito.lt 372100. 465 = 5H0548.648 After tax rate After tax rate cost of debt Cost of debt =PV, (int) =PU2 (1-tz) = 372100-465(1-0.35) -540548.6481- 0034) = $241865.30225 =351356, 6212 HY2 -

cost + > when we look at WACC in a bigger picture, weste that wicca cost of of debt equity This question focusses on Cost of debt, looking at it frother wer first calculate the PV of the band eive then multiply (1-taxrate) to the PV to calculate the cost of debt. This is called the after tax rate cost of debt. And hence for Royal Incos after a cate cost of debt $241865. 30225 > Higher x tax rate benefits the debt financing because tax rate can deduce interest expense and dividends on common shares are higher. the * Please -- please kindly Up-vote. Thank you