. Fargo Industries has outstanding 30 year bonds at 7% semiannual payments. The bond sells at 90% of its face value. If their tax rate is 22%:
a.What is the aftertax cost of debt?
b. What is the pretax cost of debt?
c. Which is more important in calculating the cost of capital for Fargo, a or b?
To calculate the aftertax and pretax cost of debt for Fargo Industries, we need to consider the interest payments and the tax rate. Let's break down the steps to find the answers:
a. Aftertax Cost of Debt:
The aftertax cost of debt takes into account the interest tax shield, which is the tax savings resulting from deducting interest expenses from taxable income.
Step 1: Calculate the coupon payment:
The coupon payment is calculated by multiplying the face value of the bond by the coupon rate. Since the bond is semiannual, divide the coupon rate by 2.
Coupon payment = (Face value of the bond) * (Coupon rate / 2)
Step 2: Calculate the interest expense:
The interest expense is the pretax cost of debt, which is equal to the coupon payment.
Interest expense = Coupon payment
Step 3: Calculate the tax savings:
The tax savings are the interest expense multiplied by the tax rate.
Tax savings = Interest expense * Tax rate
Step 4: Calculate the aftertax cost of debt:
The aftertax cost of debt is the pretax cost of debt minus the tax savings.
Aftertax cost of debt = Pretax cost of debt - Tax savings
b. Pretax Cost of Debt:
The pretax cost of debt is the interest expense divided by the bond price, giving us the yield-to-maturity (YTM) before considering taxes.
Pretax cost of debt = Interest expense / Bond price
c. Importance in Calculating the Cost of Capital:
Both the aftertax cost of debt and the pretax cost of debt are important in calculating the cost of capital. However, the aftertax cost of debt is usually more relevant since it reflects the true cost to the company after tax savings.
Now, let's plug in the given information to calculate the answers:
Bond price = 90% of the face value
Tax rate = 22%
You will need the additional information of the face value and the coupon rate to calculate the aftertax and pretax cost of debt for Fargo Industries.