Question

Baxter International Inc. can obtain funds for future investments through retained earnings, new issues of common stock, and issuance of debt. Baxter's stock currently sells for $18 per share, paid a dividend of $1.20 last year (D₀=$1.20), has a growth rate of 6% that is expected to continue, and new issues carry flotation costs of 7%. Baxter's bonds sell for $945, pays a 7% annual coupon, matures in 30 years, and new issues carry 3% flotation costs. Baxter's tax rate is 30%. What is Baxter's after-tax cost of debt?

a. 7.72%

b. 5.40%

c. 5.22%

d. 7.46%

e. 4.90%

Answer 1

Given about Baxter International Inc.'s bond,

Current price = $945

Face value = $1000

coupon rate = 7%

So, annual coupon = 7% of 1000 = $70

years to maturity = 30 years,

flotation cost F = 3%

Price of the bond after flotation cost payment = price*(1-F)

So adjusted price = 945*(1-0.03) = $916.65

Yield to maturity of the bond can be calculated on financial calculator using following values:

FV = 1000

PV = -916.65

PMT = 70

N = 30

Compute for I/Y, we get I/Y = 7.72%

For a company, its pretax cost of debt Kd equals its bond's YTM

So, Baxter's pretax cost of debt Kd = 7.72%

tax rate = 30%

So, after-tax cost of debt = Kd*(1-tax rate) = 7.72*(1-0.3) = 5.40%

So, Baxter's after-tax cost of debt = 5.40%

Option B is correct.