[cpaswag]

NINJA Question –

*my question where did the 1,000 come from in the hypothetical? Correct answer was C. If you can walk me thru wrong answers it would be good : If Brewer Corporation’s bonds are currently yielding 8% in the marketplace, why would the firm’s cost of debt be lower?
Incorrect A.
Market interest rates have increased.
B.
Additional debt can be issued more cheaply than the original debt.
C.
Interest is deductible for tax purposes.
D.
There is a mixture of old and new debt. Brewer Corporation’s cost of debt is lower than the current yield of their bonds because interest expenses are tax deductible.
The cost of capital is almost always calculated on an after-tax basis, since the payments to the suppliers of the capital are made from after-tax cash flows. Consider a firm with interest expense of $80 annually:
Case A: Firm With Interest Case B: Firm Without Interest
EBIT $100 EBIT $100
less Int (80) less Int 0 —– —– EBT 20 EBT 100 less Tax (40%) ( 8) less Tax (40%) (40) —– —– EAT $ 12 EAT $ 60 The firm with interest expense has cash flows that are $48 less than a no-interest case, not the $80 less that would be expected without the tax benefit. The cost of debt to the firm is: Interest × (1 – Tax rate). The cost of the interest is thus Interest × (1 – .40), or $80 × .6 = $48.
8% bonds paying $80 in interest per year would have a face value of $1,000 ($1,000 × 8% = $80).
The actual after tax cost of debt for case A would be 4.8% ($48 ÷ $1,000), which would be lower than the marketplace 8%.

[Anonymous]

$1,000

Face value is the nominal value or dollar value of a security stated by the issuer. For stocks, it is the original cost of the stock shown on the certificate. For bonds, it is the amount paid to the holder at maturity, generally $1,000. It is also known as “par value” or simply “par.”

Face Value Definition | Investopedia

http://www.investopedia.com/terms/f/facevalue.asp

[Author]

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