Question

Avicorp has a $ 14.4 million debt issue outstanding, with a 6.2 % 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 93 % 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 a.

Par Value = $1,000

Current Price = 93% * Par Value

Current Price = 93% * $1,000

Current Price = $930

Annual Coupon Rate = 6.20%

Semiannual Coupon Rate = 3.10%

Semiannual Coupon = 3.10% * $1,000

Semiannual Coupon = $31

Time to Maturity = 5 years

Semiannual Period = 10

Let Semiannual YTM be i%

$930 = $31 * PVIFA(i%, 10) + $1,000 * PVIF(i%, 10)

Using financial calculator:

N = 10

PV = -930

PMT = 31

FV = 1000

I = 3.961%

Semiannual YTM = 3.961%

Pretax Cost of Debt = (1 + Semiannual YTM)^2 - 1

Pretax Cost of Debt = (1 + 0.03961)^2 - 1

Pretax Cost of Debt = 1.0808 - 1

Pretax Cost of Debt = 0.0808 or 8.08%

Answer b.

After-tax Cost of Debt = Pretax Cost of Debt * (1 - tax)

After-tax Cost of Debt = 8.08% * (1 - 0.40)

After-tax Cost of Debt = 4.85%

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