Question

HDC has a twenty –year bond outstanding with a 5 percent coupon. The face amount of the bond is $1,000. What is the company's after – tax cost of debt is the tax rate is 40%?

a. 2%

b. 5%

c. 6%

d. 3%

Answer 1

Ans:- In this question, we need to find the after-tax cost of debt. For that first, we need to find the YTM (yield to maturity). In this question, face value is given $1,000 but the selling price of the bond is not given, therefore we will assume the selling price is equal to its face value i.e $1000

Nper = 20, Pmt = $1000 * 5% = 50, PV =-$1000, FV = $1000.

YTM is 5%. After-tax cost of debt is given by YTM * (1 - Tax-rate) = 5% * (1 - 0.40) = 3%.

Therefore the after-tax cost of debt is 3%. option (d) is the right answer.

Note:- If bonds face value is equal to its selling price then coupon rate will be equal to its Yield to Maturity (YTM).