Shanken Corp. issued a bond with a maturity of 16 years and a semiannual coupon

Question

Shanken Corp. issued a bond with a maturity of 16 years and a semiannual coupon rate of 6 percent 2 years ago The bond currently sells for 91 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).) Pretax cost of debt 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).) Aftertax cost of debt Which is more relevant, the pretax or the aftertax cost of debt? Aftertax cost of debt O Pretax cost of debt

Explanation / Answer

Time to maturity = 14 years

Assume the face value to be $100

Semi Annual Coupon = (6%/2) * 100 = 0.03 * 100 =$3

Price of the bond = 91% * 100 = $91

According the formula for bond pricing, the price of the bond is present value of the future cash flows discounted at the yield to maturity (YTM) .Since, this is a semi annual bond, discount rate would be YTM/2.

91 = 3/(1 + YTM/2)1 + 3/(1 + YTM/2)2 + 3/(1 + YTM/2)3 + _ _ _ _ _ + 3/(1 + YTM/2)27 + 103/(1 + YTM/2)28

It can be caculated using the RATE function of excel. The syntax for the same is: =RATE(28,3,-91,100)

YTM/2 = RATE(28,3,-91,100) = 3.51%

YTM = 3.51% * 2 = 7.02%

a) Pretax cost of debt = YTM of the bonds = 7.02%

b)After tax cost of Debt = Pretax cost of debt * (1 - Tax Rate) = 7.02% * (1 - 35%) = 4.56%

c)After tax cost of debt is more relevant because the interest expense is tax deductible or provides the tax shield due to which the tax of the company gets reduced thereby effectively loweing the cost of debt. This tax shield is captured by the after tax cost of debt. Hence, it is more relevant.

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.