Question

Avicorp has a $11.1 million debt issue​ outstanding, with a 5.9% coupon rate. The debt has​ semi-annual 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.

a. What is​ Avicorp's pre-tax cost of​ debt? Note: Compute the effective annual return.

b. If Avicorp faces a 40 % tax​ rate, what is its​ after-tax cost of​ debt?

​Note: Assume that the firm will always be able to utilize its full interest tax shield.

Answer 1

Answer to Part a:

Face Value = $11,100,000
Current Price = 95% * $11,100,000
Current Price = $10,545,000

Annual Coupon Rate = 5.90%
Semiannual Coupon Rate = 2.95%
Semiannual Coupon = 2.95% * $11,100,000
Semiannual Coupon = $327,450

Time to Maturity = 5 years
Semiannual Period to Maturity = 10

Let semiannual YTM be i%

$10,545,000 = $327,450 * PVIFA(i%, 10) + $11,100,000 * PVIF(i%, 42)

Using financial calculator:
N = 10
PV = -10545000
PMT = 327450
FV = 11100000

I = 3.553%

Semiannual YTM = 3.553%

Annual YTM = (1 + Semiannual YTM)^2 - 1
Annual YTM = (1 + 0.03553)^2 - 1
Annual YTM = 1.0723 - 1
Annual YTM = 0.0723 or 7.23%

Pre-tax Cost of Debt = 7.23%

Answer to Part b:

Pre- Tax Cost of Debt = 7.23%
Tax Rate = 40%
After-Tax Cost of Debt = 7.23% * (1 – 0.40)
After-Tax Cost of Debt = 4.34%