Peyton’s Colt Farm issued a 30-year, 7 percent semiannual bond 7 years ago. The bond currently sells for 94 percent of its face value. The company’s tax rate is 35 percent. What is the pre tax cost of debt?
To calculate the pre-tax cost of debt, we need to take into account the current market price of the bond and the coupon rate.
First, let's determine the annual coupon payment. Since it is a semiannual bond, the coupon payment is calculated as the face value multiplied by the coupon rate divided by two:
Coupon Payment = (Face Value) x (Coupon Rate / 2)
Next, we need to calculate the yield to maturity (YTM) of the bond. The YTM represents the average return the investor will earn by holding the bond until maturity. We can use the bond's current market price and remaining years to maturity to estimate the YTM. In this case, the bond has 23 years remaining until maturity (30 years total minus the 7 years that have already passed).
Now that we have the coupon payment and the yield to maturity, we can calculate the pre-tax cost of debt using the following formula:
Pre-tax Cost of Debt = (Annual Coupon Payment) / (Bond Price) + (YTM)
Finally, we will multiply the pre-tax cost of debt by (1 - Tax Rate) to account for the tax advantage of interest payments. In this case, the tax rate is 35%.
Pre-tax Cost of Debt = (1 - Tax Rate) x (Pre-tax Cost of Debt)
Let's calculate the pre-tax cost of debt step by step:
1. Calculate the annual coupon payment:
Coupon Payment = (Face Value) x (Coupon Rate / 2)
= (Face Value) x (0.07 / 2)
2. Calculate the yield to maturity (YTM) based on the bond's current market price of 94% of face value and its remaining years to maturity of 23 years. The YTM can be determined using financial calculators or spreadsheet functions such as the RATE function in Excel.
3. Calculate the pre-tax cost of debt by using the formula:
Pre-tax Cost of Debt = (Annual Coupon Payment) / (Bond Price) + (YTM)
4. Adjust the pre-tax cost of debt for the tax advantage by multiplying it by (1 - Tax Rate):
Pre-tax Cost of Debt = (1 - Tax Rate) x (Pre-tax Cost of Debt)
By following these steps, you can calculate the pre-tax cost of debt for Peyton's Colt Farm.