Question

Mila purchased a Zaffre Corporation $100,000 bond 10 years ago for its face value. The bond pays 5% interest annually. In a “Type E” reorganization, Zaffre exchanges Mila’s bond with 10 years remaining for a 15-year bond also having a face value of $100,000 but paying 4.5% annual interest. Mila earns a 3% after-tax rate of return, and she is in the 25% tax bracket for all years. Determine whether this is an equitable exchange for Mila. Hint: Use text Appendix F in your analysis. 

Answer 1

Formula to calculate cost of debt is,

K_d = Interest (1- Tax rate ) / Amount of debt

In case of Mila purchase

K_d = $5,000 (1- 0.25 ) / $100,000 = 3.75%

In case of Zaffre exchange

K_d = $4,500 (1- 0.25 ) / $100,000 = 3.37%

Analysing Table

Particulars	Mila Purchase	Zaffre Exchane
Kd	3.75%	3.37%

on the other hand Mila is earning 3% after tax which means her earnings after tax is = $100,000*3/100 = $3,000

Conclusion :

Since cost of debt is lower in case of zaffre exchange therefore mila can take this option.