The pretax cost of debt depends on the book value of the bonds. The bonds may have been issued at a discount or a premium. The market value is not relevant. If you don't know at what amount the bonds were issued, you can't find the effective interest cost.
A bond consists of two promises. It promises to pay $1,000 on the maturity date, and it promises to pay periodic interest. The interest payments are determined by the coupon rate. If the coupon rate of interest is more than the market rate, the bond will sell at a premium because it is more attractive than the rate available in the market. So it's price will be bid up. The bidding will stop when its yield to maturity equals the market interest rate. If the coupon rate is less than the market rate, the bond will sell at a discount.
By discounting the two future cash flows to the present using the market interest rate, you can find the present value of the bond, the price at which it will sell. In a diagram you have
PV - - - PMT - - - PMT - - - - - - PMT - - - PMT + $1,000
PMT is the interest payment calculated from the coupon rate. The number of payments is determined by the life of the bond. So you have variables whose values are known and you can solve for any unknown variable when you know the others. The simplest way is using a financial calculator. The variables are
Maturity value - $1,000 face value per bond
Coupon rate - determines size of PMT
PMT = periodic interest = Face value * coupon rate * time
Number of periods is usually semiannual, sometimes annual
Market rate: Used to discount future cash flows
PV = present value of the future cash flows
A bond's coupon rate is fixed and does not change during the life of the bond. But market interest changes in reaction to a variety of economic conditions. So if a bond has a 5% coupon rate, and investors can now earn only 4% in the market, the 5% bond will be very attractive. Investors will all want it so they will bid for it and its price will go up. That is, when market interest rates fall below the bond's coupon rate the price of the bond will increase.
The opposite is true if market interest rates go up. The price of the bond will go down. If investors can earn 6% interest why should they buy a bond that pays only 5%. They will buy it only if the price is low enough to yield 6%. So bond prices move in opposite directions from interest rate.
You'll learn more if you do your own homework. That's the purpose of homework.
I can do your homework. Your parents paid big bucks so you could too.
Titans, Inc. has 6 percent bonds outstanding that mature in 14 years. The bonds pay interest semiannually and have a face value of $1,000. Currently, the bonds are selling for $993 each. What is the firm's pretax cost of debt?
