Question

A company's 6% coupon rate, semiannual payment, $1,000 par value bond that matures in 20 years sells at a price of $604.27. The company's federal-plus-state tax rate is 40%. What is the firm's after-tax component cost of debt for purposes of calculating the WACC? (Hint: Base your answer on the nominal rate.) Round your answer to two decimal places.

Answer 1

Firm's after-tax component cost of debt for purposes of calculating the WACC

The After-tax Cost of Debt is the after-tax Yield to maturity of the Bond

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
Face Value [$1,000]	FV	1,000
Coupon Amount [$1,000 x 6% x ½]	PMT	30
Yield to Maturity [YTM]	1/Y	?
Time to Maturity [20 Years x 2]	N	40
Bond Price [-$604.27]	PV	-604.27

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 = 10.90%

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

= 10.90% x (1 – 0.40)

= 10.90% x 0.60

= 6.54%

“Therefore, the firm's after-tax component cost of debt for purposes of calculating the WACC will be 6.54%”