In: Finance
Western Gas & Electric Company (WGC) can borrow funds at an interest rate of 7.30% for a period of seven years. Its marginal federal-plus-state tax rate is 45%. 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 $1,136.50 per bond, carry a coupon rate of 12%, and distribute annual coupon payments. The company incurs a federal-plus-state tax rate of 45%. 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.)
1) 6.72%
2) 4.48%
3) 5.60%
4) 6.44%
WGC’s after-tax cost of debt
WGC’s after-tax cost of debt = Interest Rate x (1 – Tax Rate)
= 7.30% x (1 – 0.45)
= 7.30% x 0.55
= 4.02%
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)
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 [-$1,136.50] |
PV |
-1,136.50 |
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 = 10.19%.
After Tax Cost of Debt = Yield to maturity x (1 – Tax Rate)
= 10.19% x (1 – 0.45)
= 10.19% 0.55
= 5.60%
“Hence, the Reasonable estimate for the After-tax cost of Debt will be 5.60%”