Question

The Holmes Company's currently outstanding bonds have a 7% coupon and a 12% yield to maturity. Holmes believes it could issue new bonds at par that would provide a similar yield to maturity. If its marginal tax rate is 35%, what is Holmes's after-tax cost of debt? Round your answer to two decimal places.

Answer 1

To calculate Holmes Company's after-tax cost of debt, we need to consider the tax shield provided by the tax deductibility of interest payments. Here are the steps to calculate it:

Calculate the before-tax cost of debt:

The yield to maturity represents the before-tax cost of debt. In this case, it is given as 12%.

Calculate the tax shield:

The tax shield is the tax savings resulting from deducting interest expenses from taxable income. It is equal to the before-tax cost of debt multiplied by the marginal tax rate. In this case, the marginal tax rate is 35%.

Tax Shield = Before-Tax Cost of Debt * Marginal Tax Rate

Tax Shield = 12% * 35% = 0.12 * 0.35 = 0.042 (or 4.2%)

Calculate the after-tax cost of debt:

The after-tax cost of debt is the before-tax cost of debt minus the tax shield.

After-Tax Cost of Debt = Before-Tax Cost of Debt - Tax Shield

After-Tax Cost of Debt = 12% - 4.2% = 7.8%

Therefore, Holmes Company's after-tax cost of debt is 7.8%.