Question

Carraway Seed Company is issuing a $1,000 par value bond that pays 11 percent annual interest and matures in 9 years. Investors are willing to pay $985 or the bond. Flotation costs will be 11 percent of market value. The company is in a 25 percent tax bracket. What will be the? firm's after-tax cost of debt on the? bond?

The? firm's after-tax cost of debt on the bond will be nothing?%. (Round to two decimal places.)

Answer 1

We need to calculate the YTM of this bond in order to calculate the cost of debt. For manual calculations, we can only calculate approx YTM. For exact calculations, we need Excel or financial calculator. I have shown both the methods below, and you can use whichever, depending upon availability of excel/financial calculator. (Remember approx YTM means answer would be near by and not exact).

Approx YTM is mathematically represented as:

For bond in question, C = $1000 * 11% = $110, n = 9 years, F = $1000, P (adjusted for floatation cost) = $985 * (1 - 11%) = $876.65. Substituting these values in formula,

Approx YTM = 13.18%

Exact Calculation in Excel is shown in snapshot below:

Exact YTM = 13.44%

{I am using exact YTM for calculation of after tax cost of debt}

After tax cost of debt = YTM * (1 - Tax Rate) = 13.44% * (1 - 25%) = 10.08%--> Answer