[SIMmer Down]

The capital structure of a firm includes bonds with a coupon rate of 12% and an effective interest rate of 14%. The corporate tax rate is 30%. What is the firm’s net cost of debt?

a. 9.8%

b. 8.4%

Choice “a” is correct. The net cost of debt is computed as the effective interest rate net of tax, or 14% × .70 = 9.8%. The question is trying to trick the candidate into using the coupon rate of 12% rather than the effective interest rate. The coupon rate is used only if it is the same as the effective interest rate and there are no flotation costs.

Choice “b” is incorrect. The net cost of debt is computed as the effective interest rate net of tax, or 14% × .70 = 9.8%, not the coupon rate of 12% × .70 = 8.4%.

I chose answer choice B because:

If I’m not mistaken, the coupon rate is what’s being paid out to the holder of the bond. Hence, the amount paid out would be the amount of the tax deduction the entity would get. The cash savings, not to be confused with the tax deduction amount, would be 3.6% = 12% * 30%. So it follows that the net debt cost would be 8.4% = 12% – 3.6% cash savings. Another way to solve it would be 8.4% = 12% * 70%

[tuanxn]

Hey there, unfortunately we do use the effective interest rate for this problem. What probably occurred is that the company issued the bonds when the market interest rate was 14%. Since their bonds only paid 12%, they probably had to discount the bonds so that the effective interest rate amounted to 14%. The discounted amount accounts for the 2% difference. Thus, every interest interval will result in an interest expense of 14% (12% from the coupon rate and 2% from the discount).

Does that help?

[ohiostategirlcpa]

The effective rate takes into consideration any discount or premium on the bond principal, in addition to the coupon interest. It is a more complete measurement of interest cost than just the coupon rate.

The tax shield (deduction) applies to the interest expense, and if you took FAR first, you'd know that the premium/discount is actually classified as a periodic interest expense.

F91 A95 R90 B94
CMA since 2015
(Gleim books/PDFs, MCQs, SIMS)

[sdguy]

I'll echo what everyone said above. Also will add, it will help if you understand the journal entry.

The coupon rate accounts for the credit to cash. However the Debit to Interest Expense is based on the effective interest rate. The difference is either a debit or credit to discount or premium amortization.

AUD: 83
FAR: 77
REG: 86
BEC: 86

[SIMmer Down]

‘The coupon rate accounts for the credit to cash. However the Debit to Interest Expense is based on the effective interest rate. The difference is either a debit or credit to discount or premium amortization. – See more at: https://www.another71.com/cpa-exam-forum/topic/why-is-the-effective-interest-rate-being-used-instead-of-the-coupon-rate#sthash.bMhlV3B7.dpuf‘

Thank you all who posted, the above made it make sense.

[JSPERBER]

Only use the Coupon rate if the the problem tells you that the bond was issued at par. When the examiners doesn't explicitly state that, use the effective interest rate. Use the effective rate dude.

[Author]

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