Question

The approximate after tax cost of debt to a firm in the 40% tax bracket for a 20 year, 12% coupon, $1000 par value bond selling for $950 is:

		9.49%
		9.00%
		7.20%
		3.60%
		5.69%

Answer 1

We can calculate the value of after tax cost of debt to firm as follows

Par Value	$ 1,000
Current Sale Price	$ 950
Coupon rate	12%
Coupon Payments	$ 120
Time Period	20 years
Tax rate	40%

Net Sales proceeds of the company = $ 950 , as the bond sells at this price so the company will receive $ 950 for every bond issued

On this bond the company wil have to pay coupon payments each year which amounts to

= par value * coupon rate

= 1000 * 12%

= $ 120

So, $ 120 will be the cost to the company.

On this cost the company will be able to save tax which would be

= coupon payment * tax rate

= 120 * 40% = $ 48

As the company is able to save $ 48 as tax on the coupon payments made, therefore the net cost of debt to company will be

= Coupon payment - savings in tax

= 120 - 48

= $ 72

Now the formula of calculating the after tax cost of debt to company will be

= Net cost / Sales proceeds

= 72 / 950

= 7.57%

So, the closest value to 7.57% as per the options given is 7.20%

Therefore the correct answer will be 7.20%.

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