Question

Waller, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with 8 years to maturity twith a current price of $1042. The issue makes semiannual payments and has coupon rate of 8 percent. If the tax rate is 0.36, what is the pretax cost of debt? Enter the answer with 4 decimals (e.g. 0.0123)

Answer 1

Assuming we can't use excel or financial calculator to calculate the YTM, we will use the approximation formula for YTM. Cost of debt is basically the YTM or current yield of the debt.

Now, in our question,

F = 1,000 (assumed)

C = 8% of $1000 = $80 annually => $40 semi-annually

P = $1042

n = 8 years = 16 semi-annual periods

=> Approx YTM = 37.375/1021 = 3.66% ---> Semi-annual

Annual YTM = 3.66% * 2 = 7.32% which is the apprx pretax cost of debt. This is our answer

(When calculated in Excel, with steps below, exact YTM comes to 7.30%)

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Some additional values :)

[Post tax cost of debt = 7.32% * (1 - 36%) = 4.68%]

Calculations in Excel shown in snapshot below. Excdel can make life easy!