Jiminy’s Cricket Farm issued a bond with 15 years to maturity and a semiannual c
ID: 2719702 • Letter: J
Question
Jiminy’s Cricket Farm issued a bond with 15 years to maturity and a semiannual coupon rate of 6 percent 2 years ago. The bond currently sells for 95 percent of its face value. The company’s tax rate is 35 percent.
What is the pretax cost of debt? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
What is the aftertax cost of debt? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
Which is more relevant, the pretax or the aftertax cost of debt?
Jiminy’s Cricket Farm issued a bond with 15 years to maturity and a semiannual coupon rate of 6 percent 2 years ago. The bond currently sells for 95 percent of its face value. The company’s tax rate is 35 percent.
Explanation / Answer
Answer:
Face Value of Bond (Assumed) = $100
Current Market Price of Bond = 95% of $100 = $95
Number of period remaining = (15-2) x 2 = 26
Interest Amount = $100 x 6% x ½ = $3
Tax Rate = 35%
Cost of Debt is the discounting rate by which all future cash flows related to bond is equal to present value of bond i.e. Present Value of Bond = Interest x PVIFA (Kd, 26) + Maturity Value of Bond x PVIF (Kd, 26)
$95 = $3 x PVIFA (Kd, 26) + $100 x PVIF (Kd, 26) ………………………………….. equation (1)
From the above equation it is clear that currently bond is selling at discount i.e. below face value.
That means required rate of return exceeds the coupon rate.
By taking discounting rate 3.29%, the value of PVIFA (3.29%, 26) = 17.295 and PVIF (3.29%, 26) = 0.431.
Putting this value into above equation (1)
= ($3 x 17.295) + $100 x 0.431 = $51.88 + $43.1 = $94.98 or $95
(a) So, the Cost of Debt before tax = 3.29% semi-annually or 6.58% annually (3.29 x 2)
(b) Cost of Debt After Tax = Cost of Debt before tax (1 – Tax) = 6.58% (1 – 0.35) = 4.277%
(c) After tax Cost is more relevant due to tax saving on interest. There is a benefit of tax saving on payment of interest on bond.
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