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 14 years to maturity that is quoted at 105 percent of face value. The issue makes semiannual payments and has an embedded cost of 4 percent annually.

What is the company’s pretax cost of debt? (Do not round intermediate calculations. Enter your answer as a percent rounded 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. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Drogo, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with 14 years to maturity that is quoted at 105 percent of face value. The issue makes semiannual payments and has an embedded cost of 4 percent annually.

Explanation / Answer

Solution:

Calculation of company’s pretax cost of debt:

N = 2 * 14 = 28

PV = 1.05 * 1,000 = 1,050

PMT = (0.04 * 1,000)/ 2 = 20

FV = 1,000

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

P0 = 1050 = 20(PVIFAR%,28) + 1,000(PVIFR%,28)

R = 1.77%

YTM = 2 * 1.77% = 3.54

Calculation of company's aftertax cost of debt:

RD(1 – TC) = 0.0354 (1-0.35)

= 0.0354 * 0.65

= 0.02301

= 2.30%

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