Question

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

For which capital component must you make a tax adjustment when calculating a firm’s weighted average cost of capital (WACC)?

Equity

Debt

Preferred stock

Andalusian Limited (AL) can borrow funds at an interest rate of 12.50% for a period of six years. Its marginal federal-plus-state tax rate is 25%. AL’s after-tax cost of debt is ________. (rounded to two decimal places).

At the present time, Andalusian Limited (AL) has 10-year noncallable bonds with a face value of $1,000 that are outstanding. These bonds have a current market price of $1,092.79 per bond, carry a coupon rate of 11%, and distribute annual coupon payments. The company incurs a federal-plus-state tax rate of 25%. If AL 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.)

8.57%

7.14%

6.43%

5.71%

Answer 1

1)

we need tax adjustment for Debt.

2)

interest rate = 12.50%

tax rate = 25%

after tax cost of debt = beforetax rate*(1 - tax)

= 12.50%*(1-25%)

= 9.375%

3)

first we have to find YTM:

coupon payment(PMT) = 1000*11% = 110

market price(PV) = 1092.79

future value(fv) = 1000

number of periods(n) = 10

using financial calculator we can find YTM(I/Y)

[N = 10 ; PV = -1092.79 ; PMT = 110 ; FV = 1000 ] computr I/Y

YTM before tax = 9.52%

After tax = 9.52*(1-0.25) = 7.14%

second option is correct.