Question

Advance, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with 14 years to maturity that is quoted at 105 percent of face value. The issue makes semiannual payments and has a coupon rate of 4 percent.

What is the company's 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.)

Pretax cost of debt % If the tax rate is 35 percent, 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.)

It is not 3.81% for before tax and 2.47% for after.I got them wrong.

Answer 1

(a)-The company's pretax cost of debt

The company's pretax cost of debt is the Yield to maturity of (YTM) of the Bond is calculated using financial calculator as follows (Normally, the YTM is calculated either using EXCEL Functions or by using Financial Calculator)

Variables	Financial Calculator Keys	Figure
Face Value [$1,000]	FV	1,000
Coupon Amount [$1,000 x 4.00% x ½]	PMT	20
Yield to Maturity [YTM]	1/Y	?
Time to Maturity [14 Years x 2]	N	28
Bond Price [-$1,000 x 105%]	PV	-1,050

We need to set the above figures into the financial calculator to find out the Yield to Maturity of the Bond. After entering the above keys in the financial calculator, we get the yield to maturity (YTM) on the bond = 1.77%.

The semi-annual Yield to maturity = 1.77%

Therefore, the annual Yield to Maturity = 3.54% [1.77% x 2]

“Hence, the company's pretax cost of debt will be 3.54%”

(b)-The after-tax cost of debt

After-tax cost of debt = Yield to maturity on the bond x (1 – Tax Rate)

= 3.54% x (1 – 0.35)

= 3.54% x 0.65

= 2.30%

“The after-tax cost of debt will be 2.30%”