Question

Bermuda Cruises issues only common stocks and coupon bonds. The firm has a debt-equity ratio of 0.45. The cost of equity is 17.6 percent. Required: What is the pre-tax cost of the company debt if weighted average costs of the company is 13.5% and the firm's tax rate is 35 percent?

Answer 1

6.75%

Step-1:Calculation of after tax cost of debt
WACC	=	(Wd*Kd)+(We*Ke)		Where,
0.1350	=	(0.31*Kd)+(0.69*0.1760)	Wd	=	Weight of debt
0.1350	=	(0.31*Kd)+(0.69*0.1760)	Kd	=	Cost of debt
0.1350	=	(0.31*Kd)+0.1214		We	=	Weight of Equity
0.0136	=	0.31*Kd			Ke	=	Cost of Equity
Kd	=	0.043889
Working:
Debt-Equity Ratio	=	Debt/Equity
0.45/1.00	=	Debt/Equity
or,
Debt	=	0.45
Equity	=	1.00
Total		1.45
or,
Weight of :
debt	=	0.45	/	1.45	=	0.31
Equity	=	1.00	/	1.45	=	0.69
Total						1.00
Step-2:Calculation of pretax cost of debt
Pretax cost of debt	=	After tax cost of debt	/	(1- Tax Rate)
	=	0.043889	/	(1-0.35)
	=	0.043889	/	0.65
	=	6.75%