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%