Bender and Co. is issuing a $1,000 par value bond that pays 9% interest annually. Investors are expected to pay $918 for the 10-year bond. What is the after-tax cost of debt if the firm is in the 34% tax bracket?

Question

Quizplus · Accepted Answer

First, we need to calculate the annual interest payment:
9% of $1,000 par value = $90 per year

Next, we need to calculate the yield to maturity (YTM) using the bond's current price of $918:
N = 10 (10 years)
PV = -$918 (negative because this is the cash outflow)
PMT = $90 (annual interest payment)
FV = $1,000 (par value)
I/Y = 5.18%

So the before-tax cost of debt is 5.18%. However, the after-tax cost of debt will be lower because interest payments are tax-deductible.

To calculate the after-tax cost of debt, we can use the following formula:
After-tax cost of debt = before-tax cost of debt x (1 - tax rate)

After-plugging in numbers:

After-tax cost of debt = 5.18% x (1 - 0.34)
After-tax cost of debt = 3.41%

Therefore, the after-tax cost of debt is 3.41%, which is closest to option A.