Question

Calculating Cost of Debt J&R Renovation, 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 95 percent of face value. The issue makes semiannual payments and has a coupon rate of 6.4 percent annually. What is the company’s pretax cost of debt? If the tax rate is 35 percent, what is the aftertax cost of debt?

Answer 1

The Approximate Yield to Maturity Formula(Semi Annual)=[Coupon +  ( Face Value - Market Price) / Number of Years to Maturity ] / [( Face Value + Market Price)/2 ] *100

= ( $1000 * 6.4%) + ( $ 1000 - $ 950) / 14 ] / [(1000 + 950)/2] *100

= 67.57142857/ 975*100

= 6.93040293%

Since this formula gives an approximate value, the financial calculators can be used alternatively.

where,

Par Value = $ 1,000

Market Price = $ 950

Annual rate = 6.4% and

Maturity in Years = 14 Years

Hence the yield to maturity = 6.97%

Hence the company’s pretax cost of debt = 6.97%

The after tax cost of debt = Yield to Maturity * (1- tax Rate)

= 6.97 % * ( 1- 35%)

= 4.5305%

Hence the correct answer is 4.53%