Advance, Inc., is trying to determine its cost of debt. The firm has a debt issu

Question

Advance, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with 16 years to maturity that is quoted at 107 percent of face value. The issue makes semiannual payments and has a coupon rate of 10 percent annually.

What is Advance's pretax cost of debt? (Do not round intermediate calculations and round your answer to 2 decimal places. (e.g., 32.16))

If the tax rate is 35 percent, what is the aftertax cost of debt? (Do not round intermediate calculations and round your answer to 2 decimal places. (e.g., 32.16))

  Cost of debt

%

Please thoroughly explain-thank you

Advance, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with 16 years to maturity that is quoted at 107 percent of face value. The issue makes semiannual payments and has a coupon rate of 10 percent annually.

Explanation / Answer

Question 1: Let the pre-tax cost of debt be R, therefore

Value of bond = Coupon rate/2 * Par value * [1 - (1 + Pre-tax cost of debt/2)-Years to maturity*2] / (Pre-tax cost of debt/2) + Par value / (1 + Pre-tax cost of debt/2)Years to maturity*2

=> 107% * Par value = 10%/2 * Par value * [1 - (1 + R/2)-16*2] / (R/2) + Par value / (1 + R/2)16*2

Through trial and error method we get,

R = 9.16%

Therefore, Pre-tax cost of debt = 9.16%

Question 2: After tax cost of debt = Pre-tax cost of debt * (1 - tax rate)

= 9.16% * (1 - 35%)

= 5.95%

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