3. Avicorp has a $12.7 million debt issue outstanding, with a 6.2% 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 96% 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.
Given about Avi Corp.
Face value of Debt = $12.7 million
Coupon rate = 6.2% paid semiannually,
So, semiannual coupon payment = (6.2%/2) of 12.7 million = 0.3937 million
years to maturity = 5 years
Price = 96% of face value = 0.96*12.70 = $12.192 million
a). So, Yield to maturity on this debt can be calculated using following values on financial calculator:
FV = 12.7
PV = *12.192
PMT = 0.3937
N = 2*5 = 10
compute for I/Y, we get I/Y = 3.583
So, semiannual yield = 3.583%
So, Yield to maturity = 2*3.583 = 7.17%
effective annual yield = (1+0.03583)^2 - 1 = 7.29%
For a company, its pre-tax cost of debt equals effective yield to maturity on its debts
So, Avicorp's pre-tax cost of debt Kd = 7.29%
b). Tax rate = 40%
=> After-tax cost of debt = (1-tax rate)*Kd = 7.29*(1-0.4) = 4.38%
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