Question

Carraway Seed Company is issuing a

$1,000

par value bond that pays

12

percent annual interest and matures in

9

years. Investors are willing to pay

$930

for the bond. Flotation costs will be

12

percent of market value. The company is in a

38

percent tax bracket. What will be the firm's after-tax cost of debt on the bond?

The firm's after-tax cost of debt on the bond will be

Answer 1

The after-tax cost of debt on the bond is the After Tax Yield To Maturity [YTM] of the Bond

Par Value = $1,000

Annual Coupon Amount = $120 [$1,000 x 12%]

Bond Price = $818.40 [$930 – ($930 x 12%)]

Maturity Years = 9 Years

Therefore, Yield to Maturity [YTM] = Coupon Amount + [(Par Value – Bond Price) / Maturity Years] / [(Par Value + Bond Price)/2]

= [$120 + {($1,000 – $818.40) / 9 Years)] / [($1,000 + $818.40) / 2}] x 100

= [($120 + $20.18) / $909.20] x 100

= 7.965%

Semiannual Yield to Maturity = 7.965%

The Annual Yield to Maturity of the Bond = 15.93% [7.965% x 2]

After Tax Cost of Debt

After Tax Cost of Debt = Bond’s YTM x [ 1 – Tax Rate]

= 15.93% x (1 – 0.38)

= 15.93% x 0.68

= 9.88%

“Therefore, the firm's after-tax cost of debt on the bond will be 9.88%”