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    Cost of debt and preferred stock

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    1)Calculate the aftertax cost of debt under each of the following conditions.

    Yield Corporate Tax Rate

    a. 8.0% 18%

    b. 12.0% 34%

    c. 10.6% 15%

    2) Acme Corp has a $1,000 par value bond outstanding with 25 years to maturity. The bond carries an annual interest payment of $88 and is currently selling for $925. Addison is in a 25 percent tax bracket. The firm wishes to know what the aftertax cost of a new bond issue is likely to be. The yield to maturity on the new issue will be the same as the yield to maturity on the old issue because the risk and maturity date will be similar.

    a. Compute the approximate yield to maturity (Formula 11-1) on the old issue and use this as the yield for the new issue.

    b. Make the appropriate tax adjustment to determine the aftertax cost of debt.

    3)Walgrens can sell preferred stock for $70 with an estimated flotation cost of $2.50. It is anticipated that the preferred stock will pay $6 per share in dividends.

    a. Compute the cost of preferred stock for Walgrens.

    b. Do we need to make a tax adjustment for the issuing firm?

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    Solution Preview

    1)Calculate the aftertax cost of debt under each of the following conditions.

    Yield Corporate Tax Rate

    a. 8.0% 18%

    b. 12.0% 34%

    c. 10.6% 15%

    The cost of debt is the after tax cost, since the interest amout is tax deductible. The after tax cost of debt is before tax cost X (1-tax rate).
    a. Yield is the before tax cost = 8% and tax rate is 18%
    after tax cost = 8% X(1-0.18) = 6.56%
    b. It is 12% X (1-.34) = 7.92%
    c. It is 10.6% X (1-0.15) = 9.01%

    2) Acme Corp has a $1,000 par value bond outstanding with 25 years to maturity. The bond carries an annual interest payment of $88 and is currently selling for $925. Addison ...

    Solution Summary

    The solution has various problems relating to calculation of after tax cost of debt and cost of preferred stock.

    $2.19

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