A bond that has a $1,000 par value (face value) and a contract interest rate of 11.9. The bonds have a current market value of $1,120 and will mature in 10 years. The firm's marginal tax is 34%.
What is the cost of capital from this bond debt?
To calculate the cost of capital from this bond debt, you need to consider both the interest payments and the tax savings resulting from the interest expense. Here's how you can calculate it step by step:
Step 1: Calculate the annual interest payment
The annual interest payment can be calculated by multiplying the par value of the bond ($1,000) by the contract interest rate (11.9%).
Interest payment = Par value x Contract interest rate
= $1,000 x 11.9%
= $119
Step 2: Determine the after-tax cost of debt
To calculate the after-tax cost of debt, you need to consider the tax savings resulting from deducting the interest expense from taxable income. The tax rate given is 34%.
After-tax cost of debt = Interest payment x (1 - Tax rate)
= $119 x (1 - 0.34)
= $119 x 0.66
= $78.54
Step 3: Determine the market value of the bond debt
The market value of the bond debt is given as $1,120.
Step 4: Calculate the cost of capital from this bond debt
The cost of capital can be calculated by dividing the after-tax cost of debt by the market value of the bond debt and then multiplying by 100 to express it as a percentage.
Cost of capital = (After-tax cost of debt / Market value of bond debt) x 100
= ($78.54 / $1,120) x 100
= 7.01%
Therefore, the cost of capital from this bond debt is 7.01%.