3. Cost of debt Aa Aa The is the interest rate that a firm pays on any new debt

Question

3. Cost of debt Aa Aa The is the interest rate that a firm pays on any new debt financing. Omni Consumer Products Company (OCP) can borrow funds at an interest rate of 10.20% for a period of six years. Its marginal federal-plus-state tax rate is 30%. OCP's after-tax cost of debt is places). (rounded to two decimal At the present time, Omni Consumer Products Company (OCP) has 10-year noncallable bonds with a face value of $1,000 that are outstanding. These bonds have a current market price of $1,092.79 per bond, carry a coupon rate of 11%, and distribute annual coupon payments. The company incurs a federal-plus-state tax rate of 30%. If OCP wants to issue new debt, what would be a reasonable estimate for its after-tax cost of debt (rounded to two decimal places)? 7.99% 6.66% 5.99% 5.33%

Explanation / Answer

Cost of debt

(Interest rate represents the cost of loan taken. It is the return paid on the amount of debt.)

After tax cost of debt = Interest rate*(1-Tax)

= 10.2%*(1-0.3)

= 7.14%

First we compute the pre tax cost of debt using I/Y function in financial calculator (N=10,FV=1000,PV=-1092.79,PMT= 11%*1000 = 110)

Rate = 9.52%

After tax cost = Interest rate*(1-Tax)

= 9.52%*(1-0.3)

= 6.66%

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