Question

Waller, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with 11 years to maturity that is quoted at 108 percent of face value. The issue makes semiannual payments and has an embedded cost of 8 percent annually. Required:

(a) What is the company's pretax cost of debt? (Do not round your intermediate calculations.)

option 1: 6.95%

option 2: 7.30%

option 3: 7.23%

option 4: 6.60%

option 5: 8.20%

(b) If the tax rate is 34 percent, what is the after-tax cost of debt? (Do not round your intermediate calculations.)

option 1: 4.36%

option 2: 4.77%

option 3: 4.03%

option 4: 4.81%

option 5: 4.59%

Answer 1

let the face value be 100

then market rate is 108

periods to maturity is 11 years that is 22 semi annual periods

coupon rate is 8% that is 4 per period

we need to calculate yield to maturity to find the cost of debt

Yield to maturity: it is defined as yield we realise on bond if we hold that bond till maturity

We use interpolation method to calculate the yield to maturity

When coupon rate is equal is to market price will be equal to face value when market rate is 4%

Value of bond when periodic interest is 3%

Value of bond is present value of cash flows

= 4(PVIFA 3% 22p) + 100(PVIF 3.% 22p)

= 4(15.9369) + 100(0.52189)= 115.94

Market rate is 115.94

By interpolation method we get

4%-(108-100)/(115.94-100)= 3.475

Annualised is 6.95%

so before tax cost of debt is 6.95%

tax rate is 34%

so after tax cost of debt is 6.95(1-0.34)=4.587% that is optiom 5