Question

The Royal Inc. is currently in the business of making kitchen cabinets. It has $400,000 in outstanding bonds with a coupon rate of 8% and a yield-to-maturity of 7.5%. The company is seeking additional financing so it can start a new venture, which involves the sales and installation of patio rooms, including spas and hot tubs. Its biggest competitor, who specializes solely in patio rooms, has $600,000 in outstanding bonds with a 9% coupon rate and an 11% yield-to-maturity. Royal's marginal tax rate is 35% and the competitor's marginal tax rate is 34%. What after-tax rate cost of debt should the Royal Inc. use in its WACC calculation? Which source of capital structure is likely to provide more tax-related benefit? (Show detailed calculations)

Answer 1

Answer a)

We will consider the marginal tax rate of the Royal Inc only but the YTM will considered similar to the YTM of the competitor.

Therefore after tax Cost of Debt that will be used for WACC will be

= YTM * (1-taxes)

= 11% * (1-0.35)

= 7.15%

Answer b)

Debt will obviously provide the cheaper cost to the co as the interest on Debt is a tax dedectible Source of finance. While the Dividends are not tax deductible as they are appropriation of profits not charge against profits. Equity is expensive.