Question

Advance, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with 10 years to maturity that is quoted at 95 percent of face value. The issue makes semiannual payment and has a coupon rate of 8 percent annually. What is Advance’s pretax cost of debt? If the tax rate is 35 percent, what is the after-tax cost of debt?

Answer 1

(a)-Advance’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 8.00% x ½]	PMT	40
Yield to Maturity [YTM]	1/Y	?
Time to Maturity [10 Years x 2]	N	20
Bond Price [-$1,000 x 95%]	PV	-950

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 = 4.38%

The semi-annual Yield to maturity = 4.38%

Therefore, the annual Yield to Maturity = 8.76% [4.38% x 2]

“Hence, Advance’s pretax cost of debt will be 8.76%”

(b)-The after-tax cost of debt

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

= 8.76% x (1 – 0.35)

= 8.76% x 0.65

= 5.69%

“The after-tax cost of debt will be 5.69%”