Question

A company’s investment banker estimates that it could sell 10-year semiannual bonds with a coupon rate of 5%. The face value would be$1,000 and the flotation costs for a bond issue would be 1%. The firm faces a 35% tax rate. What is the firm's After-tax cost of debt

Answer 1

After-Tax Cost of Debt

The After-Tax Cost of Debt is the After-Tax Yield to maturity of (YTM) of the Bond and is calculated using financial calculator as follows (Normally, the YTM is calculated either using EXCEL Functions or by using Financial Calculator)

Variables	Financial Calculator Keys	Figure
Face Value [$1,000]	FV	1,000
Coupon Amount [$1,000 x 5% x ½]	PMT	25
Yield to Maturity [YTM]	1/Y	?
Time to Maturity [10 Years x 2]	N	20
Bond Price [-$1,000 x (1 – 0.01)]	PV	-990

We need to set the above figures into the financial calculator to find out the Yield to Maturity of the Bond. After entering the above keys in the financial calculator, we get the yield to maturity (YTM) on the bond = 5.13%

The After-tax Cost of Debt is the after-tax Yield to maturity of the Bond

After Tax Cost of Debt = Yield to maturity x (1 – Tax Rate)

= 5.13% x (1 – 0.35)

= 5.13% x 0.65

= 3.33%

“Hence, the After-tax Cost of Debt will be 3.33%”