Calculate the After Tax Cost of Debt

Question 9-1

Calculate the after tax cost of debt under each of the following conditions

1. Interest rate of 13%, tax rate of 0%

Solution:

Given,

Interest rate (rd) = 13%

Tax rate (T) = 0%

Now,

To calculate the after-tax cost of debt

We have,

After-tax cost of debt = rd (1-T) = 13% ( 1-0) = 13%

Therefore, after tax cost of debt at 13% interest rate and 0% tax rate is 13%.

1. Interest rate of 13%, tax rate of 20%

Solution:

Given,

Interest rate (rd) = 13%

Tax rate (T) = 20%

Now,

To calculate the after-tax cost of debt

We have,

After-tax cost of debt = rd (1-T) = 13% ( 1-0.20) = 13% (0.8) = 10.4%

Therefore, after tax cost of debt at 13% interest rate and 20% tax rate is 10.4%.

1. Interest rate of 13%, tax rate of 35%

Solution:

Given,

Interest rate (rd) = 13%

Tax rate (T) = 35%

Now,

To calculate the after-tax cost of debt

We have,

After-tax cost of debt = rd (1-T) = 13% ( 1-0.35) = 13% (0.65) = 8.45%

Therefore, after tax cost of debt at 13% interest rate and 35% tax rate is 8.45%.

Question 9-2

LL incorporated’s currently outstanding 11% coupon bonds have a yield to maturity of 8%. LL believes it could issue new bonds at the par that would provide a similar yield to maturity. If its marginal tax rate is 35%, what is LL’s after tax cost of debt?

Solution:

Given,

Tax Rate (T) = 35%

Yield to maturity (YTM) = 8%

Now,

We have,

After tax cost of debt = rd (1-T) = 8% (1-0.35) = 8% (0.65) = 5.2%

Therefore, LL’s after tax cost of debt at 35% marginal tax rate and 8% YTM is 5.2%.

Question 9-3

Duggins Veterinary Supplies can issue perpetual preferred stock at a price of $50 a share with an annual dividend of $4.50 a share. Ignoring flotation costs, what is the company’s cost of preferred stock, rps?

Solution:

Given,

Stock Price = $50

Annual Dividend = $4.50

We have,

Cost of preferred stock (rps) = Annual Dividend / Stock Price = 4.50/50 = 0.09 or 9%

Therefore, the cost of preferred stock Duggins Veterinary Supplies is 9%.

Question 9-4

Burnwood Tech plans to issue some $60 par preferred stock with a 6% dividend. A similar stock is selling on the market for $70. Burnwood must pay flotation costs of 55 of the issue price. What is the cost of preferred stock?

Solution:

From question,

Par value of preferred stock = $60

Dividend = 6%

Selling market price of stock = $70

Flotation cost = 5%