Jiminy’s Cricket Farm issued a 18-year, 8 percent semiannual bond 3 years ago. T

Question

Jiminy’s Cricket Farm issued a 18-year, 8 percent semiannual bond 3 years ago. The bond currently sells for 92 percent of its face value. The company’s tax rate is 40 percent.

Suppose the book value of the debt issue is $45 million. In addition, the company has a second debt issue on the market, a zero coupon bond with 12 years left to maturity; the book value of this issue is $35 million, and the bonds sell for 51 percent of par.

What is the company’s total book value of debt? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.)

What is the company’s total market value of debt? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.)

What is your best estimate of the aftertax cost of debt? (Round your answer to 2 decimal places. (e.g., 32.16))

Jiminy’s Cricket Farm issued a 18-year, 8 percent semiannual bond 3 years ago. The bond currently sells for 92 percent of its face value. The company’s tax rate is 40 percent.

Suppose the book value of the debt issue is $45 million. In addition, the company has a second debt issue on the market, a zero coupon bond with 12 years left to maturity; the book value of this issue is $35 million, and the bonds sell for 51 percent of par.

Explanation / Answer

What is the company’s total book value of debt?

•The book value of debt is the total par value of all outstanding debt, so:

•BVD = 45,000,000 + 35,000,000 = $80,000,000

What is the company’s total market value of debt?

To find the market value of debt, we find the price of the bonds and multiply by the number of bonds. Alternatively, we can multiply the price quote of the bond times the par value of the bonds. Doing so, we find

MVD = 0.92 *45,000,000 + 0.51*35,000,000 = $59,250,000

What is your best estimate of the aftertax cost of debt?

•a.The pretax cost of debt is the YTM of the company’s bonds, so:

• P0 = $920

•               Coupon = 40= (1,000*8%*0.5)

•               T=(18-12)*2 = 12

Using financial calculator

Rz= 4.55%

• YTM = 2 × 4.55% = 9.10%

• b. The aftertax cost of debt is:

• RD = .0910(1 – .40) = .0546or 5.46%

c. The after-tax rate is more relevant because that is the actual cost to the company

•The YTM of the zero coupon bonds is:

• PZ = 510 = 1,000

•     T=12

YTM =(Face Value / Current Price of Bond) ^ (1 / Years to Maturity) - 1 = (1,000/510)^(1/12)-1 = 5.77%

• R =5.77%

• So, the after tax cost of the zero coupon bonds is:

• RZ = .0577(1 – 0.40) = .0346 or 3.46%

•The after tax cost of debt for the company is the weighted average of the after tax cost of debt for all outstanding bond issues. We need to use the market value weights of the bonds. The total after tax cost of debt for the company is:

RD = .0546*(414,000,000/59,250,000) + .0346*(178,500,000/ 59,250,000) = .0486 or 4.86%

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