Question

4. Avicorp has a $14.6 million debt issue outstanding, with a 6.1% 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. a. The cost of debt is % per year. (Round to four decimal places.) b. If Avicorp faces a 40% tax rate, the after-tax cost of debt is %. (Round to four decimal places.)

Answer 1

Par value of Bond(FV) = $1,000

Current Price of Bond(BV) = 93% of $1,000 = $930

Annual Coupon rate = 6.1%

Coupon frequency = Semi-annual

Semi-annual coupon payment (A) = 1000*6.1%/2 = $30.50

Coupon period until maturity (n) = 5*2 = 10

$BV = A*(P/A,r,n)+FV*(P/F,r,n)$

$930 = 30.50*(P/A,r,10)+1000*(P/F,r,10)$

by solving with trial and error method, we get

$\textup{r (semi-annual) } = 0.0390913729156379$

thus,

$\textup{Annual effective rate = } (1+0.0390913729156379)^2-1$

$\textup{Annual effective rate = } 0.0797108812677052$

$\large \textup{Annual effective rate = } 7.97\%$

Cost of Debt is 7.97% per year

Tax rate is 40%

After tax cost of debt = 7.97%*(1-40%) = 4.78%

Hope this will help, please do comment if you need any further explanation. Your feedback would be highly appreciated.