Question

Kenny Electric Company's noncallable bonds were issued several years ago and now have 20 years to maturity. These bonds have a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. If the firm's tax rate is 40%, what is the component cost of debt for use in the WACC calculation?a. 4.35% b. 4.58% c. 4.83% d. 5.08% e. 5.33%

Answer 1

Answer:

d. 5.08%

Explanation:

We have to first calculate the YTM of the bond, and then apply the tax shield.

To get the YTM we have to calculate the rate of return of an annuity of 46.25 for 20 years compounding semiannually at IRR rate and the present value of the face value redeem in 20 years.

$C \times \frac{1-(1+r)^{-time} }{rate} +Face\:Value/(1+rate)^{time}= PV$

$46.25 \times \frac{1-(1+IRR/2)^{-20*2} }{rate} + 1000/(1+IRR)^{20}= 1075$

IRR = 0.084656891 (it should be done using financial calculator or excel or a similar software program)

then we apply the shield tax to the IRR:

IRR x (1 - tax-rate) = Cost of debt

0.084656891 * ( 1 - 0.4) = 5.0794= 5.08