Question

Micro Spinoffs Inc. issued 20-year debt a year ago at par value with a coupon rate of 5%, paid annually. Today, the debt is selling at $1,140. If the firm’s tax bracket is 21%, what is its percentage cost of debt? Assume a face value of $1,000

Answer 1

Face Value = $1,000

Annual Coupon Payment = $1000*5% = $50

No of years to maturity (n) = 20 years- 1 year = 19 year (As the 20-year debt is issued 1 year ago)

Price = $1,140

Calculating Yield to Maturity (YTM) using Trial & Error method:-

As the Price is higher than the Face value, the YTM will be less than the coupon rate due to the Inverse relationship between Price and Yield.

Taking YTM as 4%

Price = $656.695 + $474.64

Price = $1,131.34

Now, since the price at YTM@4% is closer to original price. Taking another YTM as 3.5% which is closer to 4%.

YTM as 3.5%

Price = $685.49 + $520.16

Price = $1205.65

Now, Calculating YTM:-

YTM = 3.94%

So, Yield To Maturity of Debt = 3.94%

Cost of Debt after Tax = YTM*(1-Tax rate)

= 3.94%(1-0.21)

= 3.1126%

So, its percentage cost of debt is 3.1126%

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