Question

Avicorp has a $13.9 million debt issue? outstanding, with a 6.2% coupon rate. The debt has? semi-annual coupons, the next coupon is due in six? months, and the debt matures in five years. It is currently priced at 93% of par value. a. What is? Avicorp's pre-tax cost of? debt? Note: Compute the effective annual return. (Round to 4 decimal places) b. If Avicorp faces a 40% tax? rate, what is its? after-tax cost of? debt?

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 6.20% x ½]	PMT	31
Yield to Maturity [YTM]	1/Y	?
Time to Maturity [5 Years x 2]	N	10
Bond Price [-$1,000 x 93%]	PV	-930

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 = 3.96%

The semi-annual Yield to maturity = 3.96%

Therefore, the annual Yield to Maturity = 7.92% [3.96% x 2]

“Hence, the company's pretax cost of debt will be 7.92%”

(b)-The after-tax cost of debt

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

= 7.92% x (1 – 0.40)

= 7.92% x 0.60

= 4.75%

“The after-tax cost of debt will be 4.75%”