JBL has a 20-year, 8% annual coupon bonds outstanding. If the bonds currently sell for 95% of $1000 par value and the firm pays an average tax rate of 35%, what will be the before-tax and after-tax component cost of debt?
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To calculate the before-tax and after-tax component cost of debt, we'll use the formula for the cost of debt, considering the current market price of the bond.
Given:
Coupon rate = 8%
Par value = $1,000
Bonds sell for 95% of the par value = $950 ($1,000 * 95%)
1.Before-Tax Cost of Debt:
The before-tax cost of debt is essentially the yield to maturity (YTM) on the bond, which is the rate of return anticipated on a bond if held until maturity.
The formula for YTM is complex and often requires iterative methods or financial calculators. But for the sake of this calculation:
We can approximate the YTM as the coupon rate when the bond is selling at a discount (as in this case).
Therefore, the before-tax cost of debt is approximately equal to the coupon rate, which is 8%.
2.After-Tax Cost of Debt:
The after-tax cost of debt considers the tax benefit received due to the tax-deductibility of interest expenses.
Given the firm's average tax rate of 35%, the after-tax cost of debt is calculated as follows:
After-tax Cost of Debt = Before-tax Cost of Debt × (1−Tax Rate)
Before-tax cost of debt (from above) = 8%
Tax rate = 35%
After-tax Cost of Debt = 8% × (1−0.35)
After-tax Cost of Debt = 8%×0.65
After-tax Cost of Debt = 5.2%
Therefore:
Before-tax component cost of debt = 8%
After-tax component cost of debt = 5.2%