Question

The congress is considering cutting corporate tax rates to stimulate the economy. If this happens, Cuddly Pet Inc. will see its marginal tax rate drop from 40% to 30%. The company has plans to issue a $1,000 face value, 30-year bond with a 7.00% annual coupon, paid semiannually, at par. By how much would the adjusted cost of debt used to calculate the WACC change if the new tax rate was adopted?
    A.  
0.80%
    B.  
0.63%

    C.  
0.77%

    D.  
0.57%

    E.  
0.70%

Answer 1

adjusted cost of debt = YTM of bonds * (1 - tax rate)

YTM is calculated using RATE function in Excel with these inputs :

nper = 30*2 (30 years to maturity with 2 semiannual coupon payments each year)

pmt = 1000 * 7% / 2 (semiannual coupon payment = face value * annual coupon rate / 2. This is a positive figure as it is an inflow to the bondholder)

pv = -1000 (current bond price. This is a negative figure as it is an outflow to the buyer of the bond)

fv = 1000 (face value of the bond receivable on maturity. This is a positive figure as it is an inflow to the bondholder)

The RATE calculated is the semiannual YTM. To calculate the annual YTM, we multiply by 2. Annual YTM is 7.00%

40% tax rate

adjusted cost of debt = YTM of bonds * (1 - tax rate)

adjusted cost of debt = 7.00% * (1 - 40%)

adjusted cost of debt = 4.20%

30% tax rate

adjusted cost of debt = YTM of bonds * (1 - tax rate)

adjusted cost of debt = 7.00% * (1 - 30%)

adjusted cost of debt = 4.90%

Change in adjusted cost of debt =  4.90% - 4.20%

Change in adjusted cost of debt =  0.70%

The answer is E