Question

1. What is the component cost of debt in this scenario: a 10 year annual coupon bond at 8% that sells for $1125 with a tax rate of 40%?

1. 6.28%
2. 3.77%
3. 4.8%
4. 8%

Answer 1

Answer:
Calculation of cost of Debt
Formula =
Cost of debt =	Lower rate +	Price at lower rate - Current price	x (Higher rate - Lower rate)
		Price at lower rate - Price at higher rate
Price=	Present value of Cash inflows
Current price	1125.00
Present value at lower rate   =	6%			Present value at higher rate   =	8%
Year	Cash Inflows	Present value factor @ 6%	Present value of cash inflows		Year	Cash Inflows	Present value factor @ 8%	Present value of cash inflows
1	80.00	0.94340	75.47		1	80.00	0.9259	74.07
2	80.00	0.89000	71.20		2	80.00	0.8573	68.59
3	80.00	0.83962	67.17		3	80.00	0.7938	63.51
4	80.00	0.79209	63.37		4	80.00	0.7350	58.80
5	80.00	0.74726	59.78		5	80.00	0.6806	54.45
6	80.00	0.70496	56.40		6	80.00	0.6302	50.41
7	80.00	0.66506	53.20		7	80.00	0.5835	46.68
8	80.00	0.62741	50.19		8	80.00	0.5403	43.22
9	80.00	0.59190	47.35		9	80.00	0.5002	40.02
10	1080.00	0.55839	603.07		10	1080.00	0.4632	500.25
		Total	1147.20				Total	1000.00
Price at higher rate	1147.20				Price at higher rate	1000.00
Cost of Debt	6% +	22.2017	x (8-6)%
		147.2017
Cost of Debt	6% +	0.1508	*2%
Cost of Debt	6% +	0.3017	%
Cost of Debt	6.30%
	or 6.28%
Component cost of debt = cost of debt x (1 - Tax rate)
	= 6.28% (1-0.40)
	= 3.77% (Answer)