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Waller, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with 12 years to maturity which is quoted at 103 percent of face value. The issue makes semiannual payments and has an embedded cost of 7 percent annually.
a. What is the company's pretax cost of debt? (Do not round your intermediate calculations.)
b. If the tax rate is 33 percent, what is the after-tax cost of debt? (Do not round your intermediate calculations.)

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Answer:

Explanation:

The pretax cost of debt is the annual interest rate of the bond, also known as the YTM.

Using a financial calculator, input the following;

Maturity of the bond; 12*2 = 24 semiannual payments

Face value; FV = 1,000

Price of the bond; PV = - ( 1.03*1000) = -1,030

Recurring coupon payments; PMT = (7%/2) *1000 = 35

Then compute Semiannual interest rate;  CPT I/Y = 3.317%

Next, convert to annual rate (YTM) = 3.317*2 = 6.63%

Aftertax cost of debt is the adjusted YTM after taxes. Since interests paid on debt have tax shield, the aftertax cost of debt will be lower than the pretax cost of debt.

Aftertax cost of debt = Pretax cost of debt (1-tax)

= 6.63%(1-0.33)

= 4.44%

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