Question

1. The XGENZ Corporation issued a 30-year, 7 percent semiannual bond 3 years ago. The bond currently sells for 93 percent of its face value. The company’s tax rate is 35 percent.
   1. What is the pretax cost of debt?
   2. What is the aftertax cost of debt?
   3. Which is more relevant, the pretax or the aftertax cost of debt? Why?

4. Suppose the book value of the debt issue is $85 million. In addition, the company has a second debt issue on the market, a zero coupon bond with 12 years left to maturity; the book value of this issue is $35 million, and the bonds sell for 59 percent of par.
   1. What is the company’s total book value of debt?
   2. The total market value?
   3. What is your best estimate of the aftertax cost of debt now?

Answer 1

a. Number of Periods =(30-3)*2 =54
Par Value =1000
Semi annual coupon =7%*1000/2 =35
Price =93%*1000 =930
YTM using financial calculator
N=54;PMT=35;PV=-930;FV=1000;CPT =3.8074%

Cost of Debt or YTM =2*3.8074% =7.6148% or 7.61%

b. After tax cost of debt =7.6148%*(1-35%) =4.95%

c. After tax cost of debt is more relevant as interest payments are tax deductible. Hence provides benefit of interest tax shield.

d. i. Total book value of Debt =85+35 =120

ii. Total Market Value of debt =93%*Book Value of Bond+59%*Book Value of zero coupon bond
=93%*85+59%*35 =99.7

iii. Before tax cost of debt of zero coupon bond =(100/59)^(1/12)-1 =4.495%
After tax cost of Debt =(Weight of Bond*Cost of debt+Weight of zero coupon bond*Cost of debt )*(1-tax rate)
=(93%*85/99.7*7.6148%+59%*35/99.7*4.495%)*(1-35%) =4.53%