Question

Walter Corp.'s outstanding bonds have a 5.8% coupon, 5 years left until maturity, and are currently priced at $974.67. The firm's marginal tax rate is 33%. Walter's after-tax cost of debt is ____%. Round your final answer to 2 decimal places (example: enter 12.34 for 12.34%), but do not round any intermediate work in the process. {And, do not convert to effective annual yield.}

Answer 1

YTM is the rate at which the intrinsic value of bond is equal to its current market price. Intrinsic value of the bond is the present value of cash inflows from the bond, i.e., present value of coupon payments and present value of maturity value using YTM as the discount rate. The rate at which total of these present values is equal to the current market price is the YTM. It is just like IRR. IRR equates the initial outlay with the present value of cash inflows of the project. Similarly, in case of a Bond, the initial outlay is the current market price (which you pay to get the bond) and the inflows are the coupon payments and maturity value.

Assuming $1000 par value and maturity value, we first compute the before - tax cost of debt using the "RATE" formula in excel -

Annual coupon payment = $1000 x 5.8% = $58

No. of years to maturity = 5, market price = $947.67, maturity value = $1000

Therefore, Pre - tax cost of debt = 6.40801488521%

After - tax cost of debt = Pre - tax cost of debt x (1 - tax rate) = 6.40801488521% x (1 - 0.33) = 4.29336997% or 4.29% (enter as 4.29)