Question

To calculate the after-tax cost of debt, multiply the before-tax cost of debt by (1-T) Western Gas & Electric Company (WGC) can borrow funds at an interest rate of 9.70% for a period of five years. Its marginal federal-plus-state tax rate is 25%. WGC's after-tax cost of debt is (rounded to two decimal places). At the present time, Western Gas & Electric Company (WGC) has 15-year noncallable bonds with a face value of $1,000 that are outstanding. These bonds have a current market price of $1,329.55 per bond, carry a coupon rate of 12%, and distribute annual coupon payments. The company incurs a federal-plus-state tax rate of 25%. If WGC wants to issue new debt, what would be a reasonable estimate for its after-tax cost of debt (rounded to two decimal places)? (Note: Round your YTM rate to two decimal place.) 4.87% O 5.48% 06.09% O 7.00%

Answer 1

After-tax cost of Debt is calculated by multiplying the Before-tax cost of debt by (1 – Tax Rate)

WGC’s after-tax cost of debt

WGC’s after-tax cost of debt = Interest Rate x (1 – Tax Rate)

= 9.70% x (1 – 0.25)

= 9.70% x 0.75

= 7.28%

Reasonable estimate for the After-tax cost of Debt

Reasonable estimate for the After-tax cost of Debt is the after-tax Yield to maturity of (YTM) of the Bond and is calculated using financial calculator as follows (Normally, the YTM is calculated either using EXCEL Functions or by using Financial Calculator)

· The Yield to maturity of (YTM) of the Bond is the discount rate at which the Bond’s price equals to the present value of the coupon payments plus the present value of the Face Value/Par Value

· The Yield to maturity of (YTM) of the Bond is the estimated annual rate of return expected by the bondholders for the bond assuming that the they hold the Bonds until it’s maturity period/date.

· The Yield to maturity of (YTM) of the Bond is calculated using financial calculator as follows (Normally, the YTM is calculated either using EXCEL Functions or by using Financial Calculator)

Variables	Financial Calculator Keys	Figure
Par Value/Face Value of the Bond [$1,000]	FV	1,000
Coupon Amount [$1,000 x 12.00%]	PMT	120
Market Interest Rate or Yield to maturity on the Bond	1/Y	?
Maturity Period/Time to Maturity [15 Years]	N	15
Bond Price [-$1,329.55]	PV	-1,329.55

We need to set the above figures into the financial calculator to find out the Yield to Maturity of the Bond. After entering the above keys in the financial calculator, we get the yield to maturity (YTM) on the bond = 8.12%.

After Tax Cost of Debt = Yield to maturity x (1 – Tax Rate)

= 8.12% x (1 – 0.25)

= 8.12% x 0.75

= 6.09%

“Hence, the Reasonable estimate for the After-tax cost of Debt will be 6.09%”