Question

1. The firm's tax rate is 40%. 2. The current price of Legacy’s 10% coupon, noncallable bonds with 10 years remaining to maturity is $1,100.00. Legacy does not use short-term interest-bearing debt on a permanent basis. 3. The current price of the firm’s 8%, $100 par value, perpetual preferred stock is $114.00. 4. Legacy’s common stock is currently selling at $45 per share. Its last dividend (D0) was $3.00, and dividends are expected to grow at a constant rate of 6.0% in the foreseeable future. Legacy’s beta is 1.1; the yield on T-bonds is 6.0%; and the market risk premium is estimated to be 5.5%. For the over-own-bond-yield-plus-judgmental-risk-premium approach, the firm uses a 4.0% judgmental risk premium. 5. Legacy’s capital structure is 40% long-term debt, 10% preferred stock, and 50% common equity.

What is the market interest rate on Legacy’s debt, and what is the component cost of this debt for WACC purposes?

Answer 1

The component cost of the debt for Weighted Average Cost of Capital (WACC) Purpose

The component cost of the debt for WACC purposes is the After tax cost of debt which is the after-tax Yield to Maturity (YTM) of the Bond

Yield to Maturity [YTM] of the Bond

Yield to Maturity [YTM] = Coupon Amount + [(Par Value – Bond Price) / Maturity Years] / [(Par Value + Bond Price)/2]

Par Value = $1,000

Annual Coupon Amount = $100 [$1,000 x 10%]

Bond Price = $1,100

Maturity Years = 10 Years

Therefore, Yield to Maturity [YTM] = Coupon Amount + [(Par Value – Bond Price) / Maturity Years] / [(Par Value + Bond Price)/2]

= [$100 + {($1,000 – $1,100) / 10 Years)] / [($1,000 + $1,100) / 2}]

= [($100 - $10) / $1,050]

= 0.0848

= 8.48%

After Tax Cost of Debt

After Tax Cost of Debt = Bond’s YTM x [ 1 – Tax Rate]

= 8.48% x (1 – 0.40)

= 8.48% x 0.60

= 5.09%

“Therefore, the component cost of the debt for Weighted Average Cost of Capital (WACC) purpose would be 5.09%”