Question

Bermuda Cruises issues only common stocks and coupon bonds. The firm has a debt-equity ratio of 0.45. The cost of equity is 17.6 percent.

Required:

What is the pre-tax cost of the company debt if weighted average costs of the company is 13.5% and the firm's tax rate is 35 percent?

Answer 1

Debt/Equity	0.45
So equity	1
and Debt	0.45
Weight	Value	Weight	Weight	Cost	Weight * Cost
Debt	0.45	0.45/1.45	31.03%	D	D*0.3103
Equity	1	1/1.45	68.97%	17.60%	12.138%
Total	1.45
12.138%+ D*0.3103=13.50%
D*0.3103=	13.50%-12.138%
D*0.3103=	1.36%
D=	4.39%
After-tax cost of debt=	4.39%
Tax rate	35%
Pre-tax cost of debt=	4.39%/(1-35%)
Pre-tax cost of debt=	6.75%