Gargoyle Unlimited
Gargoyle Unlimited is planning to issue a zero coupon bond to fund a project that will yield its first positive cash flow in three years. That cash flow will be sufficient to pay off the entire debt issue. The bond's par value will be $1,000, it will mature in 3 years, and it will sell in the market for $727.25. The firm's marginal tax rate is 40 percent.
-Refer to Gargoyle Unlimited.What is the dollar value of the interest tax savings to the firm in the third year of the issue?
A) $32.58
B) $40.29
C) $100.72
D) $60.43
E) $109.10

Question

Quizplus · Accepted Answer

Since the bond is a zero coupon bond, there are no interest payments made during the 3-year life of the bond. Therefore, the tax savings are equal to the tax rate multiplied by the annual accretion in the bond's value. The bond's value at maturity is $1,000. Its present value is $727.25. Therefore, the annual accretion is (1,000/727.25)^(1/3) - 1 = 8.3%. The tax savings in year 3 are therefore 0.4 x ($1,000 - $727.25 x (1+8.3%)^2) = $40.29.

Gargoyle Unlimited Gargoyle Unlimited Is Planning to Issue a Zero Coupon Bond