Question

Kenny Electric Company's noncallable bonds were issued several years ago and now have 20 years to maturity. These bonds have a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. If the firm's tax rate is 25%, what is the component cost of debt for use in the WACC calculation?

Answer 1

We will use rate function in excel to calculate the cost of debt

Here,

NPER = Time left for maturity = 20 years = 40 half years (As bond pays semi annual coupon, we will use half yearly periods)

PMT = Coupons paid = Par Value x Coupon rate /2

= 1000 x 9.25% /2

= $46.25 (As coupons are paid semi annually)

PV = Current Price = - $1075 (The negative sign is indicative of cash outflow to purchase the bond. The coupons and the maturity value are cash flows for bond holder, while purchase price is cash outflow)

FV = Maturity Value = Par value = $1000

Type = 0 (In excel type 0 or 1, indicate the periodic payments at beginning (1) & end (0). Since coupons are paid at the end, we use 0 here)

Rate (Half yearly rate) = Rate(40,46.25,-1075,1000,0) = 4.23%

Annual Rate (YTM) for the bond = 4.23% x 2 = 8.46%

The after tax cost of bond (Component cost of debt to be used in WACC)

= Annual Rate x (1- Tax Rate)

= 8.46% x (1-25%)

= 6.35%