Question

ICU Windows, INC., is trying to determine its cost of debt. The firm has a debt issue outstanding with 8 years to maturity that is quoted at 103.5 percent of face value. The issue makes semiannual payments and has an embedded cost of 5.2 percent annually.

a.What is the company's pretax cost of debt?
b.If the tax rate is 21 percent, what is the aftertax cost of debt?

Answer 1

Pre Tax cost of Debt is YTM. YTM is the rate at which {PV of Cash Inflows are equal to Bond Price.

Year	CF	PVF @2%	DISC CF	PVF @2.5%	Disc CF
1	$      26.00	0.9804	$      25.49	0.9756	$      25.37
2	$      26.00	0.9612	$      24.99	0.9518	$      24.75
3	$      26.00	0.9423	$      24.50	0.9286	$      24.14
4	$      26.00	0.9238	$      24.02	0.9060	$      23.55
5	$      26.00	0.9057	$      23.55	0.8839	$      22.98
6	$      26.00	0.8880	$      23.09	0.8623	$      22.42
7	$      26.00	0.8706	$      22.63	0.8413	$      21.87
8	$      26.00	0.8535	$      22.19	0.8207	$      21.34
9	$      26.00	0.8368	$      21.76	0.8007	$      20.82
10	$      26.00	0.8203	$      21.33	0.7812	$      20.31
11	$      26.00	0.8043	$      20.91	0.7621	$      19.82
12	$      26.00	0.7885	$      20.50	0.7436	$      19.33
13	$      26.00	0.7730	$      20.10	0.7254	$      18.86
14	$      26.00	0.7579	$      19.70	0.7077	$      18.40
15	$      26.00	0.7430	$      19.32	0.6905	$      17.95
16	$      26.00	0.7284	$      18.94	0.6736	$      17.51
16	$ 1,000.00	0.7284	$    728.45	0.6736	$    673.62
PV OF Cash Inflows			$1,081.47		$ 1,013.06
Bond Price			$ 1,035.00		$ 1,035.00
NPV			$      46.47		$     -21.94

YTM per 6 Months = rate at which least +ve NPV + [ NPV at that Rate / Change in NPV due to 0.5% inc in disc Rate ] * 0.5%

= 2% + [ 46.47 / 68.41 ] * 0.5%

= 2% + (0.68*0.5%)

= 2% + 0.34%

= 2.34%

YTM per anum = 2.34% *12 /6

= 4.68%

Post Tax Cost of Debt = Pre Tax Cost of Debt * (1- Tax Rate )

= 4.68% * ( 1 - 0.21)

= 4.68% * 0.79

= 3.70%