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? Select one: a. 4.35% b. 4.58% c. 4.83% d. 5.08% e. 5.33%

Answer 1

Answer:

after tax cost of debt = 5.08

so correct option is d. 5.08%

Explanation:

given data

maturity = 20 years

annual coupon = 9.25%

sells price = $1,075

par value = $1,000

tax rate = 40%

to find out

component cost of debt

solution

we get here yield to maturity  YTM that is express as

periodic interest payment PMT × $(\frac{1-(1+YTM/2)}{YTM/2})^{-40}$ + $(\frac{par\ value}{1+YTM/2})^{40}$  = sells price   .................1

periodic interest payment PMT = par value × coupon rate ÷ 2

periodic interest payment PMT = $46.25

so from equation 1 we get

46.25 × $(\frac{1-(1+YTM/2)}{YTM/2})^{-40}$ + $(\frac{par\ value}{1+YTM/2})^{40}$  = 1075

YTM = 8.46 %

and

after tax cost of debt will be here as

after tax cost of debt = YTM ( 1- tax rate )

after tax cost of debt = 8.46% ( 1- 40% )

after tax cost of debt = 5.08

so correct option is d. 5.08%