Financial Management

1. XYZ Company has bonds outstanding with 7 years left before maturity. The bonds are
currently selling for $800 per $1,000 face value. The interest is paid annually at a rate
of 12 percent. The firm’s tax rate is 40 percent. Calculate the after-tax cost of debt.

Formula for before tax cost of debt:

rd = I + ($1,000 – Nd /n) / (Nd + $1,000 /2)

rd = $800, n = 7 yrs, I = (0.12*1000 = 120)

rd = 120 + ($1,000 – $800 /7) / ($800 + $1,000 /2)

rd = 16.5%

Formula for after tax cost of debt:

ri = rd  (1 – T)
16.5%* (1 – 40%) = 9.9%

2. Calculate the after-tax cost of debt under each of the following conditions:

Formula: ri = rd  (1 – T)

a. Interest rate of 13%, tax rate of 0%

13%* (1 – 0%) = 13%

b. Interest rate of 13%, tax rate of 20%

13%* (1 – 20%) = 10.4%

c. Interest rate of 13%, tax rate of 35%

13%* (1 – 35%) = 8.5%

3. If a company has to float preferred stock and its floating cost is 2.5% and it pays 8%
dividend then what would be the cost of capital.

Formula: rP = DP/Np
(Multiply the face value (100) for preferred stock by dividend %age = 0.08*100), N p = 100 - F.C

8 / 97.5 = 8.2%