Shanken Corp. issued a 30-year, 6.2 percent semiannual bond 7 years ago. The bond currently sells for 108 percent of its face value. The company’s tax rate is 35 percent. (Assume that the face value of one coupon bond is $1,000.) a. What is the pretax cost of debt? b. What is the aftertax cost of debt? c. Which is more relevant, the pretax or the aftertax cost of debt? Why?

a. Pretax cost of debt is 4.84%.

b. Aftertax cost of debt is 3.15%.

c. Aftertax cost of debt is more relevant. The reason is that it is the actual cost of debt to the company.

Explanation:

a. What is the pretax cost of debt?

The bond's Yield to Maturity can be calculated using the following RATE function in Excel:

YTM = RATE(nper,pmt,-pv,fv) * 2 (1)

Where;

YTM = yield to maturity = ?

nper = number of periods = number of semiannuls to maturity = Number of years * Number of semiannuals in a year = 7 * 2 = 14

r = Semiannual coupon rate = Annual coupon rate / 2 = 6.2% / 2 = 0.062 / 2 = 0.031

pmt = semiannual coupon payment = fv * r = 1000 * 0.031 = $31 = 31

pv = present value = current bond price = fv * 108% = 1000 * 108% = 1080

fv = face value or par value of the bond = 1000

Substituting the values into equation (1), we have:

YTM = RATE(25,90,-1250,1000) (2)

YTM = RATE(14,31,-1080,1000)*2

Inputting =RATE(14,31,-1080,1000)*2 into excel (Note: as done in the attached excel file), the YTM is obtained as 4.84%.

Therefore, the YTM of 4.84% is the pretax cost of debt.

b. What is the aftertax cost of debt?

Aftertax cost of debt = Pretax cost of debt * (100% - Tax rate) = 4.84% * (100% - 35%) = 3.15%

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

Aftertax cost of debt is more relevant. The reason is that it is the actual cost of debt to the company.

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