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Suppose that Smith Company is considering a new project
Suppose that Smith Company is considering a new project. They are trying to determine the required rate of return for their debt and equity holders. See the information below:
- A 7.5% percent annual coupon bond with 20 years to maturity, selling for 104 percent of par. The bonds make semiannual payments. What is the before tax cost of debt? If the tax rate is 40%, what is the after-tax cost of debt?
Expert Solution
Computation of Before Tax Cost of Debt using Rate Function in Excel:
=rate(nper,pmt,-pv,fv)*2
Here,
Rate = Before Tax Cost of Debt = ?
Nper = Number of Periods to Maturity = 20 Years*2 = 40 Periods
PMT = Periodic Coupon Payment = $1,000*7.5%/2 = $37.50
PV = Price of Bond = $1,000*104% = $1,040
FV = Face Value = $1,000
Substituting the values in formula:
=rate(40,37.50,-1040,1000)*2
Rate or Before Tax Cost of Debt = 7.12%
After Tax Cost of Debt = Before Tax Cost of Debt*(1-Tax rate)
= 7.12%*(1-40%)
After Tax Cost of Debt = 4.27%
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