Olympic Sports has two issues of debt outstanding. One is a 6% coupon bond with a face value of $35 million, a maturity of 10 years, and a yield to maturity of 7%. The coupons are paid annually. The other bond issue has a maturity of 15 years, with coupons also paid annually, and a coupon rate of 7%. The face value of the issue is $40 million, and the issue sells for 94% of par value. The firm's tax rate is 40%.
a.
What is the before-tax cost of debt for Olympic? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)
Before-tax cost of debt
%
b.
What is Olympic's after-tax cost of debt? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)
After-tax cost of debt
%
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a. To calculate the before-tax cost of debt for Olympic, we can use the yield to maturity (YTM) of the 6% coupon bond. The yield to maturity represents the average annual return that an investor can expect to earn if they hold the bond until maturity and reinvest all coupon payments at the YTM rate.
The formula to calculate the before-tax cost of debt is as follows:
Before-tax cost of debt = Yield to maturity (YTM)
In this case, the YTM is given as 7%. Therefore, the before-tax cost of debt for Olympic is 7%.
b. To calculate the after-tax cost of debt for Olympic, we need to consider the tax rate of 40%. The after-tax cost of debt is the before-tax cost of debt adjusted for the tax benefits resulting from the tax-deductibility of interest expenses.
The formula to calculate the after-tax cost of debt is as follows:
After-tax cost of debt = Before-tax cost of debt x (1 - Tax rate)
Using the before-tax cost of debt calculated in part a (7%) and the tax rate of 40%, we can plug the values into the formula:
After-tax cost of debt = 7% x (1 - 40%)
= 7% x 0.6
= 4.2%
Therefore, the after-tax cost of debt for Olympic is 4.2%.