Drogo, Inc., is trying to determine its cost of debt. The firm has a debt issue

Question

Drogo, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with 11 years to maturity that is quoted at 104 percent of face value. The issue makes semiannual payments and has an embedded cost of 4 percent annually.

(a) What is the pretax cost of debt?

(b) If the tax rate is 35%, what is the aftertax cost of debt?

Drogo, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with 11 years to maturity that is quoted at 104 percent of face value. The issue makes semiannual payments and has an embedded cost of 4 percent annually.

(a) What is the pretax cost of debt?

(b) If the tax rate is 35%, what is the aftertax cost of debt?

Explanation / Answer

Let Face value of Debt be F; So Market value of Debt = 104%*F = 1.04F

Time= 11 years; As there are semiannual payments so No. of payments,n = 2*11 = 22.

Similarly rate of bond, r1= 4% but its effective rate per annual = r/2= 2%

Market price of Bond = (Coupon Payment ×1(1+K)-n)/K+Face Value of Debt/(1+K)n

Coupon Payment= (Rate of Bond/ No. of Payments per year)*Face Value of Debt= 2%* F =0.02F

Now by Putting the values in Market price formula

We get K(Pretax Cost of Debt)= 0.0356= 3.56%

Now if Tax rate,T= 35%= 0.35 so After tax Cost of Debt= K(1-T)= 3.56(0.65)= 2.31%

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