Peyton’s Colt Farm issued a 30-year, 9.6 percent semiannual bond 6 years ago. The bond currently sells for 87.5 percent of its face value. The company’s tax rate is 38 percent.
What is the pretax cost of debt?
What is the after tax cost of debt?
To calculate the pretax cost of debt, we need to consider the current yield to maturity of the bond. The yield to maturity represents the annual return an investor can expect if they hold the bond until maturity.
First, let's determine the price of the bond. The bond is currently selling for 87.5 percent of its face value, so if we assume a face value of $100, the bond price would be $87.50 ($100 x 0.875).
Next, we need to calculate the yield to maturity. Since the bond pays semiannual interest, the yield to maturity will be twice the semiannual coupon rate. The coupon rate is 9.6 percent, so the semiannual coupon rate is 4.8 percent (9.6 percent / 2).
To calculate the yield to maturity, we can use a financial calculator or spreadsheet software. Alternatively, we can use an online bond calculator. Let's assume the yield to maturity for this bond is 6 percent.
The pretax cost of debt is equal to the yield to maturity, which in this case is 6 percent.
Now, to calculate the after-tax cost of debt, we need to consider the tax rate. The after-tax cost of debt takes into account the interest expense tax shield, which reduces the cost of debt for companies that can deduct interest expense from their taxable income.
To calculate the after-tax cost of debt, we need to multiply the pretax cost of debt by one minus the tax rate. In this case, the tax rate is 38 percent, so one minus the tax rate is 0.62 (1 - 0.38).
The after-tax cost of debt is equal to the pretax cost of debt multiplied by one minus the tax rate. If the pretax cost of debt is 6 percent, then the after-tax cost of debt is 6 percent multiplied by 0.62, which equals 3.72 percent.
Therefore, the pretax cost of debt is 6 percent, and the after-tax cost of debt is 3.72 percent.