Question

Contrail Air, Inc is trying to determine its cost of debt. The company has an outstanding debt issue with 18 years to maturity that is quoted at 95.00% percent of face value. The issue makes semiannual payments and has a coupon rate of 8.00% percent. What is the after tax cost of debt?

Settlement	01/01/2000
Maturity	01/01/2018
Price (% of par)	95
Coupon rate	8%
Payments per year	2
Tax rate	35%
Pretax cost	8.55%

5.56%

11.54%

6.33%

13.15%

Answer 1

Information provided:

Face value= future value= $1,000

Time= 18 years*2= 36 semi-annual periods

Present value= 95%*1,000= $950

Coupon rate= 8%/2= 4%

Coupon payment= 0.04*1,000= $40

The question is solved by first calculating the before tax cost of debt which is the yield to maturity.

Enter the below in a financial calculator to compute the yield to maturity:

FV= $1,000

N= 36

PMT= 40

PV= -950

Press the CPT key and I/Y to compute the yield to maturity.

The value obtained is 4.2746.

                                   

Hence, the yield to maturity is 4.2746%*2= 8.55%.

After tax cost of debt= Before tax cost of debt*(1 – tax rate)

                                 = 8.55%*(1- 0.35)

                                 = 5.56%.

Hence, the answer is option a.        

In case of any query, kindly comment on the solution.