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

Question:

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%

a.

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%

b.

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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Capital Structure & the Cost of Capital

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Chapter 15 / Lesson 1
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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.


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