Gargoyle Unlimited
Gargoyle Unlimited is planning to issue a zero coupon bond to fund a project that will yield its first positive cash flow in three years. That cash flow will be sufficient to pay off the entire debt issue. The bond's par value will be $1,000, it will mature in 3 years, and it will sell in the market for $727.25. The firm's marginal tax rate is 40 percent.
-Refer to Gargoyle Unlimited.What is the expected after-tax cost of this debt issue?
A) 11.20%
B) 4.48%
C) 6.72%
D) 6.10%
E) 4.00%

Question

Quizplus · Accepted Answer

The after-tax cost of debt for a zero coupon bond can be calculated using the formula for yield to maturity (YTM) on a zero coupon bond, which is [(Face Value / Present Value)^(1/n)] - 1, where n is the number of years until maturity. Here, it is [(1000 / 727.25)^(1/3)] - 1 = 0.112 or 11.20% before tax. The after-tax cost of debt is then 11.20% * (1 - 0.40) = 6.72%.

Gargoyle Unlimited Gargoyle Unlimited Is Planning to Issue a Zero Coupon Bond