Advance, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with 18 years to maturity which is quoted at 107% of face value. The issue makes semiannual payments and has a coupon rate of 8%.
a. What is the company's pretax cost of debt?
b. If the tax rate is 35%, what is the after-tax cost of debt?
Capital Structure & the Cost of Capital
Capital structure deals with how a firm finances its overall operations and growth through different sources of funds, which may include debt such as bonds or loans, among other types.
Answer and Explanation:
Face Value = $1,000
Current Price = 107%*$1,000 = $1,070
Annual Coupon Rate = 8%
Semi-annual Coupon Rate = 4%
Semi-annual Coupon = 4%*$1,000 = $40
Semi-annual Period to Maturity = 36 (18 years)
Let Semi-annual YTM be i%
Using financial calculator:
N = 36
PV = -1070
PMT = 40
FV = 1000
I/Y = 3.65%
Semi-annual YTM = 3.65%
Annual YTM = 2 * 3.65% = 7.30%
Before-tax Cost of Debt = 7.30%
After-tax Cost of Debt = 7.30%*(1-0.35)
After-tax Cost of Debt = 0.73*0.65
After-tax Cost of Debt = 4.75%
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fromChapter 15 / Lesson 1
In this lesson, we'll define capital and a firm's capital structure. We'll also discuss the costs associated with each component in the capital structure and learn about the concept of risk and return.