ICU Window, inc, is trying to determine its cost of debt. The firm has a debt issue outstanding with 8 years to maturity that is quoted at 106.5 percent of face value. The issue makes semiannual payments and has an embedded cost of 6.4 percent annually. What is ICU's pretax cost of debt? If the tax rate is 23 percent, what is the aftertax cost of debt?
ICU Window, inc, is trying to determine its cost of debt. The firm has a debt issue outstanding with 8 years to maturity that is quoted at 106.5 percent of face value. The issue makes semiannual payments and has an embedded cost of 6.4 percent annually. What is ICU's pretax cost of debt? If the tax rate is 23 percent, what is the aftertax cost of debt?
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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![### Understanding Cost of Debt Calculation
**ICU Window, Inc.** is trying to determine its cost of debt. The firm has a debt issue outstanding with 8 years to maturity that is quoted at 106.5 percent of face value. The issue makes semiannual payments and has an embedded cost of 6.4 percent annually. The question posits:
**What is ICU's pretax cost of debt?**
And if the tax rate is 23 percent, **what is the after-tax cost of debt?**
#### Detailed Breakdown:
1. **Debt Issue Details:**
- **Time to Maturity:** 8 years
- **Quoted Price:** 106.5% of face value
- **Payment Frequency:** Semiannual
- **Annual Embedded Cost:** 6.4%
2. **Calculating Pretax Cost of Debt:**
- Convert the annual cost to a semiannual rate (since payments are semiannual):
\[
\text{Semiannual interest rate} = \frac{6.4\%}{2} = 3.2\%
\]
- Determining the actual price paid versus the face value gives us:
\[
\text{Price} = 106.5\% = 1.065 \text{ (as a decimal)}
\]
- With an 8-year term and semiannual payments, you have 2 * 8 = 16 periods.
3. **After-Tax Cost of Debt Calculation:**
- Given a tax rate of 23%, the after-tax cost of debt can be calculated as follows:
\[
\text{After-tax cost of debt} = \text{Pretax cost of debt} \times (1 - \text{Tax Rate})
\]
So, to determine the after-tax cost, you multiply the pretax cost by (1 - 0.23).
#### Application in Financial Planning:
Understanding these calculations is crucial for financial planning and corporate finance management, particularly in making decisions about financing through debt versus other means. The cost of debt impacts the overall cost of capital, influencing project evaluations and long-term financial strategies.
Use this breakdown to solve similar problems by following the given steps: identifying the components of the debt issue, calculating pretax costs, and adjusting for tax impacts.](/v2/_next/image?url=https%3A%2F%2Fcontent.bartleby.com%2Fqna-images%2Fquestion%2Fce618159-930e-4ade-8eed-109751c2dc39%2F60cf178e-e35c-41bf-9bc2-d6bc32f94992%2F7p8gil.png&w=3840&q=75)
Transcribed Image Text:### Understanding Cost of Debt Calculation
**ICU Window, Inc.** is trying to determine its cost of debt. The firm has a debt issue outstanding with 8 years to maturity that is quoted at 106.5 percent of face value. The issue makes semiannual payments and has an embedded cost of 6.4 percent annually. The question posits:
**What is ICU's pretax cost of debt?**
And if the tax rate is 23 percent, **what is the after-tax cost of debt?**
#### Detailed Breakdown:
1. **Debt Issue Details:**
- **Time to Maturity:** 8 years
- **Quoted Price:** 106.5% of face value
- **Payment Frequency:** Semiannual
- **Annual Embedded Cost:** 6.4%
2. **Calculating Pretax Cost of Debt:**
- Convert the annual cost to a semiannual rate (since payments are semiannual):
\[
\text{Semiannual interest rate} = \frac{6.4\%}{2} = 3.2\%
\]
- Determining the actual price paid versus the face value gives us:
\[
\text{Price} = 106.5\% = 1.065 \text{ (as a decimal)}
\]
- With an 8-year term and semiannual payments, you have 2 * 8 = 16 periods.
3. **After-Tax Cost of Debt Calculation:**
- Given a tax rate of 23%, the after-tax cost of debt can be calculated as follows:
\[
\text{After-tax cost of debt} = \text{Pretax cost of debt} \times (1 - \text{Tax Rate})
\]
So, to determine the after-tax cost, you multiply the pretax cost by (1 - 0.23).
#### Application in Financial Planning:
Understanding these calculations is crucial for financial planning and corporate finance management, particularly in making decisions about financing through debt versus other means. The cost of debt impacts the overall cost of capital, influencing project evaluations and long-term financial strategies.
Use this breakdown to solve similar problems by following the given steps: identifying the components of the debt issue, calculating pretax costs, and adjusting for tax impacts.
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