Question

(Cost of debt​) Carraway Seed Company is issuing a ​$1000 par value bond that pays 11 percent annual interest and matures in 12 years. Investors are willing to pay ​$945 for the bond. Flotation costs will be 11 percent of market value. The company is in a 20 percent tax bracket. What will be the​ firm's after-tax cost of debt on the​ bond?

Answer 1

Information provided:

Par value= $1,000

Time= 12 years

Coupon rate= 11%

Coupon payment= 0.11*1,000= $110

Current price= present value= $945

Flotation cost= 11%

The question is solved by first calculating the pre tax cost of debt.

The flotation cost is ignored as it is incurred when new stock is issued.

The pretax cost of debt is calculated by computing the yield to maturity.

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

FV= 1,000

P= -945

N= 12

I/Y= 110

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

The value obtained is 11.8831.

Therefore, the pretax cost of debt is 11.88%.

After tax cost of debt= before tax cost of debt*(1 – tax)

                                        = 11.88%*(1 – 0.20)

                                        = 9.5040%   9.50%.

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