At the present time, Perpetualcold Refrigeration Company (PRC) has 15-year noncallable bonds with a face value of $1,000 that are outstanding. These bonds have a current market price of $1,329.55 per bond, carry a coupon rate of 12%, and distribute annual coupon payments. The company incurs a federal-plus-state tax rate of 35%. If PRC wants to issue new debt, what would be a reasonable estimate for its after-tax cost of debt (rounded to two decimal places)

Perpetualcold Refrigeration Company (PRC)

The reasonable estimate for PRC's after-tax cost of debt is:

= 0.08.

Explanation:

a) Data and Calculations:

Face value of 15-year noncallable bonds outstanding = $1,000 per bond

Current market price per bond = $1,329.55

Coupon rate of bonds = 12% per annum

Federal-plus-state tax rate = 35%

Cost of new debt = $120 per annum ($1,000 * 12%)

After-tax cost of debt = $120 (100% - 35%)

= $120 * 65%

= $78

= $78/$1,000 = 0.078

= 0.08

b) The cost of PRC's new debt is the calculated rate that the company will pay on its new debt. The major differentiating factor between the cost of debt and the after-tax cost of debt is the deduction of interest expense.  In PRC's capital structure decisions, determining the cost of debt, especially the after-tax cost of debt, and comparing it with the cost of equity involve some rigorous financial computations.

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