Clipper Co.is issuing a $1000 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

The after-tax cost of debt is calculated as the yield to maturity (YTM) on the bond multiplied by (1 - tax rate). The YTM, which is the interest rate that equates the present value of the bond's payments to its price, can be approximated since the exact calculation requires solving for the rate in the bond pricing formula. However, given the information, we can estimate the cost of debt before taxes using the interest payment and the price of the bond. The annual interest is $90 (9% of $1000). The approximate yield, ignoring the effect of the bond discount amortization for simplicity, would be $90 / $918 = 9.8%. The after-tax cost of debt = 9.8% * (1 - 0.34) ≈ 6.47%. The provided choices do not exactly match this calculation due to the simplification, but the closest and correct choice given the options and considering the tax effect is 6.83%, which suggests a more precise calculation of the YTM would be closer to this value.