A firm can issue $1000 par value bond that pays $100 per year in interest at a price of $980

Business Oct 07, 2020

A firm can issue $1000 par value bond that pays $100 per year in interest at a price of $980. The bond will have a 5-year life. The firm is in a 35% tax bracket. What is the aftertax cost of debt? A) 10.33% B) 10.20% C) 6.63% D) 6.84%

Expert Solution

We first find the YTM of the bond which is the before tax cost of debt. The YTM is the discount rate that will make the present value of interest and principal equla to the price today. Interest is an annuity and principal is a lumpsum. We get
980 = 100 X PVIFA (5,ytm) + 1,000 X PVIF (5, ytm)

You can use trial and error method or use the RATE function in excel to get the YTM. Using excel we get the YTM as 10.53%

After Tax cost of debt = Before tax cost X (1-tax rate)
After tax cost = 10.53% X (1-0.35) = 6.84%

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