A new floating-rate debt issue pays interest annually based on the one-year Trea

Question

A new floating-rate debt issue pays interest annually based on the one-year Treasury bill rate. Assume zero issuance cost. The issue matures in five years. The current one-year Treasury bill rate is 9% and the forecast one-year rates over the next four years are 9.25%, 9.5%, 9.75%, and 10%. The coupon equals the beginning-of-period Treasury rate plus 100 basis points. There is no sinking fund.

Project the debt service payment stream

Calculate the pretax cost of debt

Calculate the after-tax cost of debt, assuming a 34% tax rate.

Explanation / Answer

Year Coupon Pre-tax Cost of Debt After-tax Cost of Debt=Pretrax cost of Debt*(1-t)) 1 10% 10% 6.60% 2 10% 10% 6.60% 3 10% 10% 6.60% 4 10% 10% 6.60%

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