Question

Pearce’s Cricket Farm issued a 30-year, 7% semiannual bond 5 years ago. The bond currently sells for 95% of its face value. The company’s tax rate is 35%. Assume the par value of the bond is $1,000.

a. What is the pre-tax cost of debt? (Do not round intermediate calculations. Round the final answer to 3 decimal places.)

Pre-tax cost of debt            %

b. What is the after-tax cost of debt? (Do not round intermediate calculations. Round the final answer to 3 decimal places.)

After-tax cost of debt            %

c. Which is more relevant, the pre-tax or the after-tax cost of debt?

• a)After-tax cost of debt

• b)Pre-tax cost of debt

Answer 1

a. pre tax cost of debt has to be found using RATE function in EXCEL

=RATE(nper,pmt,pv,fv,type)

Please remember that bond pays semi-annual coupons and number years left to maturity is 25 years

nper=total number of periods=2*25=50

pmt=semi-annual coupon payment=(7%*face value)/2=(7%*1000)/2=35

pv=95%*1000=950

fv=1000

=RATE(50,35,-950,1000,0)=3.72%

Annual yield=pre tax cost of debt=2*3.72%=7.44%

b. After tax cost of debt=before tax cost of debt*(1-tax rate)=7.44%*(1-35%)=4.84%

c. the after tax cost of debt is more relevent because for the cost of debt, companies will get tax benefits by showing it for the tax purposes in the books of accounts. Hence, while do calculating the cost of debt we have to use only after tax cost of debt.