Question

1. Company A has a debt issue outstanding with a 6% coupon rate and 10 years to maturity. The debt is BB+ rated and is trading at $913.21 per bond. At this price, the bonds have a yield to maturity of 7.25%. The 10-year Treasury bond yield is 4.25%. What is Company A's pretax cost of debt?

2. Company B has a publicly-traded bond issue of $400 million outstanding. These bonds have a 5.25% annual coupon rate, 20 years remaining to maturity, and an A- rating. If these bonds are currently selling at par value, what is your estimate of the firm’s cost of debt?

3. Avicorp has a $10 million debt issue outstanding, with a 6% coupon rate. The debt has semiannual coupons, the next coupon is due in six months, and the debt matures in five years. It is currently priced at 95% of par value.

   1. What is Avicorp’s pretax cost of debt?

   2. If the marginal tax rate is 40%, what is its after-tax cost of debt?

Answer 1

1) Pre tax cost of debt is nothing but yield to maturity of current bonds outstanding. Dield to maturity of current bonds outstanding is 7.25% , hence pre tax cost of debt = 7.25%

2) When coupon rate is equal to YTM , then bonds trades at par value. Here bond is trading at par value , hence YTM = coupon rate = 5.25%

Thus firm's cost of debt = 5.25%

3) Here Face value = $1000

Interest = Face value x coupon rate

=1000 x 6% x 1/2

=$30

n = no of coupon payments = 5 x 2 = 10

Current value = 1000 x 95% = 950$

YTM = Interest +(Face value -current market price/n) / (Face value + current market price/2)
=30 + (1000-950)/10 / (1000+950)/2
=30 + (50/10) / 1950/2
=30 + 5 /975
=35/975
=0.03589
Thus annual YTM = 0.03589 x 2 = 0.07179
i.e 7.18%
Thus before tax cost of debt = 7.18%
After tax cost of debt = before tax cost of debt (1-tax rate)
=7.18%(1-40%)
=7.18%(0.6)
=4.31%