Question

In: Finance

6. The Lincoln Company sold a $1,000 par value, noncallable bond several years ago that now...

6. The Lincoln Company sold a $1,000 par value, noncallable bond several years ago that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $955 and the company's tax rate is 25%. What is the component cost of debt for use in the WACC calculation?

a. 5.35%
b. 6.28%
c. 6.04%
d. 5.58%
e. 5.81%

Solutions

Expert Solution

Component cost of debt for use in the WACC calculation

· The cost of debt for use in the WACC calculation id the after-tax Yield to maturity of the Bond

· The Yield to maturity (YTM) of the Bond is the discount rate at which the Bond’s price equals to the present value of the coupon payments plus the present value of the Face Value/Par Value

· The Yield to maturity of (YTM) of the Bond is the estimated annual rate of return expected by the bondholders for the bond assuming that the they hold the Bonds until it’s maturity period/date.

· The Yield to maturity of (YTM) of the Bond 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 7.00% x ½]

PMT

35

Market Interest Rate or Yield to maturity on the Bond

1/Y

?

Maturity Period/Time to Maturity [20 Years x 2]

N

40

Bond Price/Current market price of the Bond [-$955]

PV

-955

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 semi-annual yield to maturity on the bond (1/Y) = 3.72%

The semi-annual Yield to maturity = 3.72%

Therefore, the annual Yield to Maturity of the Bond = 7.44% [3.72% x 2]

The after-tax cost of debt

The firm’s after-tax cost of debt on the Bond is the after-tax Yield to maturity (YTM)

The After-tax cost of debt = Annual Yield to maturity on the bond x (1 – Tax Rate)

= 7.44% x (1 – 0.25)

= 7.44% x 0.75

= 5.58%

Therefore, the Component cost of debt for use in the WACC calculation will be 5.58%

jeff jeffy answered 2 years ago
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