Jiminy\'s Cricket Farm issued a 30-year, 7.2 percent semiannual bond 9 years ago

Question

Jiminy's Cricket Farm issued a 30-year, 7.2 percent semiannual bond 9 years ago. The bond currently sells for 85.5 percent of its face value. The book value of this debt issue is $107 million. In addition, the company has a second debt issue, a zero coupon bond with 12 years left to maturity; the book value of this issue is $66 million, and it sells for 61 percent of par. The company

Jiminy's Cricket Farm issued a 30-year, 7.2 percent semiannual bond 9 years ago. The bond currently sells for 85.5 percent of its face value. The book value of this debt issue is $107 million. In addition, the company has a second debt issue, a zero coupon bond with 12 years left to maturity; the book value of this issue is $66 million, and it sells for 61 percent of par. The company

Explanation / Answer

Part a)

The after tax cost of bond can be calculated with the use of EXCEL/Financial Calculator. The formula/function for calculating cost of debt is Rate(Nper,PMT,PV,FV) where Rate = Cost of Debt, Nper = Period, PMT = Interest Amount, PV = Present Value of Bonds, FV = Face Value of Bonds

______________

Here, Nper = (30-9)*2 = 42, PMT = 1,000*7.2%*1/2 = 36, PV = 1,000*85.50% = $855 and FV = $1,000

Using these values in the above formula, we get,

Cost of Debt = Rate(42,36,-855,1000)*2 = 8.72% (we multiply by 2 to get annual cost of debt)

After Tax Cost of Debt = Cost of Debt*(1-Tax Rate) = 8.72%*(1-30%) = 6.10%

__________________

Part b)

The after tax cost of bond can be calculated with the use of EXCEL/Financial Calculator. The formula/function for calculating cost of debt is Rate(Nper,PMT,PV,FV) where Rate = Cost of Debt, Nper = Period, PMT = Interest Amount, PV = Present Value of Bonds, FV = Face Value of Bonds

______________

Here, Nper = 12, PMT = 1,000*0 = 0, PV = 1,000*61% = $610 and FV = $1,000

Using these values in the above formula, we get,

Cost of Debt = Rate(12,0,-610,1000) = 4.21%

After Tax Cost of Debt = Cost of Debt*(1-Tax Rate) = 4.21%*(1-30%) = 2.94%

__________________

Part c)

After tax cost of debt is calculated with the use of weight of different types of bonds and their respective costs in the capital structure. The formula that can be used to calculate the after tax cost of debt would be:

After Tax Cost of Debt = Market Value of Bond 1/(Market Value of Bond 1 + Market Value of Bond 2)*After Tax Cost of Debt of Bond 1 + Market Value of Bond 2/(Market Value of Bond 1 + Market Value of Bond 2)*After Tax Cost of Debt of Bond 2

Market Value of the Bond = Book Value of the Bond*Current Selling Price

______________

Here, Market Value of Bond 1 = 107 million*85.5% = 91.485 million, Market Value of Bond 2 = 66 million*61% = $40.26 million, After Tax Cost of Bond 1 = 6.10% and After Tax Cost of Bond 2 = 2.94%

Using these values in the above formula, we get,

After Tax Cost of Debt = 91.485/(91.485+40.26)*6.10% + 40.26/(91.485+40.26)*2.94% = 5.13% or 5.14% (a slight difference as a result of rounding off)

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