Question

2. An overview of a firm's cost of debt To calculate the after-tax cost of debt, multiply the before-tax cost of debt by (1-1) Western Gas & Electric Company (WGC) can borrow funds at an interest rate of 12.50% for a period of six years. Its marginal federal-plus-state tax rate is 25%. WGC's after-tax cost of debt is 9.38% (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% 7.00% 7.31% 6.09%

Answer 1

Answer a.

To calculate the after-tax cost of debt, multiply the before-tax cost of debt by (1 - T).

Answer b.

Before-tax Cost of Debt = 12.50%

After-tax Cost of Debt = 12.50% * (1 - 0.25)
After-tax Cost of Debt = 9.38%

Answer c.

Face Value = $1,000
Current Price = $1,329.55

Annual Coupon Rate = 12.00%
Annual Coupon = 12.00% * $1,000
Annual Coupon = $120

Time to Maturity = 15 years

Let Annual YTM be i%

$1,329.55 = $120 * PVIFA(i%, 15) + $1,000 * PVIF(i%, 15)

Using financial calculator:
N = 15
PV = -1329.55
PMT = 120
FV = 1000

I = 8.1213%

Annual YTM = 8.1213%

Before-tax Cost of Debt = 8.1213%
After-tax Cost of Debt = 8.1213% * (1 - 0.25)
After-tax Cost of Debt = 6.09%