Question

Shanken Corp. issued a 25-year, 5.1 percent semiannual bond 3 years ago. The bond currently sells for 103 percent of its face value. The company's tax rate is 21 percent.

a. What is the pretax cost of debt? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

b. What is the aftertax cost of debt? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

c. Which is more relevant, the pretax or the aftertax cost of debt?

Aftertax cost of debt

Pretax cost of debt

Answer 1

a. The pretax cost of debt is :

Let us FV of the bond be $1000,

The coupon payments = 5.1% * 1000/ 2

= $25.5

Since, the bond is issued 3 years ago, there is 22 years left before the bond will mature.

N= 66 years (22*3)

PV = ($1030)

The cost of debt is = 2.4577%

So, the annual cost of debt = 4.9154% with annual compounding

= 4.92 (rounded off to two decimal places)

b. The after tax cost of debt: 4.9154* (1-0.21)

= 3.88% (rounded off to two decimal places)

c. The after tax cost of debt is more relevant, as it is the actual cost to the company.