Darktree Inc. has $10 million of 10% bonds outstanding that are valued at $9 million. Darktree's corporate tax rate is 15%. What is the cost of debt to Darktree?

Question

Quizplus · Accepted Answer

The cost of debt is the interest rate that Darktree Inc. pays to its bondholders. To calculate the cost of debt, we need to use the formula:

Cost of debt = Interest expense / (Net proceeds - Flotation costs)

Interest expense = 10% x $10 million = $1 million

Net proceeds = Market value of the bonds = $9 million

Flotation costs are not given, so we assume them to be zero.

Cost of debt = $1 million / ($9 million - $0) = 11.1%

However, we need to adjust for taxes since interest expense is tax-deductible. The after-tax cost of debt is:

After-tax cost of debt = Cost of debt x (1 - Tax rate)

= 11.1% x (1 - 0.15) = 9.4%

Therefore, the cost of debt to Darktree Inc. is 9.4% (Choice C).