Suspect Corp. issued a bond with a maturity of 25 years and a semiannual coupon rate of 10 percent 4 years ago. The bond currently sells for 97 percent of its face value. The book value of the debt issue is $45 million. In addition, the company has a second debt issue on the market, a zero coupon bond with 11 years left to maturity; the book value of this issue is $45 million and the bonds sell for 53 percent of par. The company's tax rate is 38 percent.

a. What is the company's total book value of debt? (Do not round Intermediate calculations.)

b. What is the company's total market value of debt?

c. What is your best estimate of the aftertax cost of debt?

Question

Business

Martha Clay

18 November, 07:12

Suspect Corp. issued a bond with a maturity of 25 years and a semiannual coupon rate of 10 percent 4 years ago. The bond currently sells for 97 percent of its face value. The book value of the debt issue is $45 million. In addition, the company has a second debt issue on the market, a zero coupon bond with 11 years left to maturity; the book value of this issue is $45 million and the bonds sell for 53 percent of par. The company's tax rate is 38 percent.

a. What is the company's total book value of debt? (Do not round Intermediate calculations.)

b. What is the company's total market value of debt?

c. What is your best estimate of the aftertax cost of debt?

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Answers (1)

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Anahi · Answer 1

a. The total book value of debt is $90,000,000.

b. The total market value of debt is $67,500,000.

c. the best estimate of the company cost of debt is 4%.

Explanation:

a. The book value of debt is the actual amount borrowed which is $45,000,000 for the 25 year bond and $45,000,000 for the zero coupon bond making a total of $90,000,000 for the two outstanding debts,

b. The market value of debt is the amount for which the bond is selling at the bonds market. The 25 year bond is currently selling for $0.97 which makes the market value to be ($0.97 x $45,000,000) giving a sum of $43,650,000 while the zero coupon bond sales for $0.53 per unit giving a market value of ($0.53 x $45,000,000) $23,850,000. Thus the total market value of debt is the sum of the two market values giving $67,500,000.

c. the best estimate of the cost of capital is computed using the ratio of market value of each debt component as a denominator of the sum of market value of both debts multiplied by the interest rate and adjusted by (1-tax rate). For the 25 year bond, the cost is calculated as: $43,650,000/$45,000,000 x 10% x (1-38%) giving a cost of debt of 4.01%. But for the zero coupon bond, the cost of debt will be the same as the yield to maturity since the debt is publicly traded. The yield is calculated as (nominal value/market value) ^ (1/years left) - 1 x (1-tax rate) which is ($23.85m/$45m) ^ (1/11) - 1 x (1-38%) giving a yield of approximately 3.68%. Thus the cost of debt for Suspect Ltd is the sum of the cost of both debts (4.01% + 3.68%) giving 7.69%.