Jiminy’s Cricket Farm issued a bond with 30 years to maturity and a semiannual c

Question

Jiminy’s Cricket Farm issued a bond with 30 years to maturity and a semiannual coupon rate of 8 percent 3 years ago. The bond currently sells for 93 percent of its face value. The company’s tax rate is 35 percent.

What is the pretax cost of debt? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

What is the aftertax cost of debt? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Which is more relevant, the pretax or the aftertax cost of debt?

Jiminy’s Cricket Farm issued a bond with 30 years to maturity and a semiannual coupon rate of 8 percent 3 years ago. The bond currently sells for 93 percent of its face value. The company’s tax rate is 35 percent.

Explanation / Answer

a. We are not told a face value, so I will assume a $1000 face value.

There are n= 30-3 = 27years to maturity = 44 semiannual periods to maturity
Coupon = 8% x 1000 = $80 annually = $40 semi-annually
Therefore, set up the value equation

930 = (40/r) ( 1- (1+r)^(-44) ) + [ 1000/ (1+r)^44 ]

Guess and chck for values of r. Note: r is a semiannual rate.

The bond sells at a discount, so therefore the yield to materity must be less than the coupon rate (i.e. less than 8% / 2 = 4% semiannually) .

r = 0.0430629

r = 4.31%

Pre tax cost of debt = 4.31 x 2 = 8.62%

b. After tax cost of debt = 8.62(1-0.35) = 5.60%

c. After tax cost of debt is more relevant, as it considers tax savings on interest.

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