Does anyone have a clue how to figure out before cost of debt?

In Wiley 2009 edition pg 207 problem #123???

I am lost at how they got the answer of 8.5%??

anyone help?

thanks

Brian

Ill do it tomorrow when I get to work

thanks

B

I was just doing the same problem in Becker yesterday, Question CPA-03951.  I thought you'd take the cost of debt that the company already has (12% less tax), but I guess when they say "current" net cost they mean what the company can issue new debt for??  Can anyone explain why?

Question CPA-03951

Martin Corporation
Statement of Financial Position
December 31, 1994
(Dollars in millions)
Assets
Current assets $ 75
Plant and equipment 250
Total assets $325

Liabilities and shareholders' equity
Current liabilities $ 46
Long-term debt (12%) 64
Common equity:
Common stock, $1 par 10
Additional paid-in capital 100
Retained earnings 105
Total liabilities and shareholders' equity $325

Additional Data
• The long-term debt was originally issued at par ($1,000/bond) and is currently trading at $1,250 per bond.
• Martin Corporation can now issue debt at 150 basis points over U.S. treasury bonds.
• The current risk-free rate (U.S. treasury bonds) is 7 percent.
• Martin's common stock is currently selling at $32 per share.
• The expected market return is currently 15 percent.
• The beta value for Martin is 1.25.
• Martin's effective corporate income tax rate is 40 percent.

Martin Corporation's current net cost of debt is:
a. 5.5 percent.
b. 7.0 percent.
c. 5.1 percent.
d. 8.5 percent.

Becker Explanation
Choice "c" is correct. 5.1 percent current net cost of debt.
Decimal %
Basis points over U.S. Treasury bond rate 150 150
One basis point = 1/100 of 1% × .0001 .01%
.015 1.5%
Current risk-free rate (U.S. Treasury bonds = baseline) .070 7.0
Pretax cost .085 8.5
Income tax at 40% .034 3.4
Net (after-tax) cost of debt (60%) .051 5.1%

Wiley explanation
The requirement is to calculate the current net cost of debt. The current cost of debt before tax is 8.5% (7% Treasury bond rate + 1.5%), and the cost of debt after tax is
5.1 % [8.5% x (1- 40% tax rate)]. Therefore, the correct answer is (c).