Avicorp has a $11.3 million debt issue outstanding, with a 6.1% coupon rate. The debt has semi-annual coupons, the next coupon is due in six months, and the debt matures in five years. It is currently priced at 95% of par value.
a. What is Avicorp's pre-tax cost of debt? Note: Compute the effective annual return.
b. If Avicorp faces a 40% tax rate, what is its after-tax cost of debt? Note: Assume that the firm will always be able to utilize its full interest tax shield.
Answer :
(a.) Calculation of Cost of Debt :
Cost of Debt can be calculated Rate function of Excel :
=RATE(nper,pmt,pv,fv)
where
nper is the number of years to maturity i.e 5 * 2 = 10 (As the coupons are paid semiannually, therefore multiplied by 2)
pmt is the coupon payment i.e 1000 * 6.1% = 61 / 2 = 30.5 (As the coupons are paid semiannually, therefore divided by 2)
pv is current market price i.e 1000 * 95% = 950
fv is the face value i.e 1000
=RATE(10,30.5,-950,1000)
By solving the answer is 3.656%. or 0.03656
Effective Annual Rate = [(1 + 0.03656)^2 - 1 ]
= 1.074455 - 1
= 0.074455 or 7.4455% or 7.45%
Therefore cost of Debt is 7.45%
(b.) Avicorp After tax cost of Debt = Pretax cost of Debt * (1 - tax rate)
= 7.4455% * (1 - 0.40)
=4.47%
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