Avicorp has a $10 million debt issue outstanding, with a 6% coupon rate. the debt has semiannual coupons, the next coupon is due in six months, and the debt matures in five years. it is currently priced at 95% of par value.

a. what is avicorp’s pretax cost of debt?
b. if avicorp faces a 40% tax rate, what is its after-tax cost of debt?

Explanation:

Pretax cost of debt is the annual rate(YTM) of the bond. Using a financial calculator, input the following to calculate it;

N = 5*2 = 10

PV = -(95% *10,000,000) = -9,500,000

Coupon PMT = (6%/2)*10,000,000 = 300,000

FV = 10,000,000

then compute semiannual rate; CPT I/Y = 3.604%

convert to annual rate = 3.604*2 = 7.21%(this is the pretax cost of debt)

After tax cost of debt is calculated because interest payable on debt has tax shield. The formula is as follows;

Aftertax cost of debt = pretax cost of debt (1-tax)

AT cost of debt = 7.21% (1-0.40)

AT cost of debt = 4.33%