Question

Suppose you are trying to estimate the after tax cost of debt for a firm as part of the calculation of the Weighted Average Cost of Capital (WACC). The corporate tax rate for this firm is 39%. The firm's bonds pay interest semiannually with a 4.8% coupon rate and have a maturity of 7 years. If the current price of the bonds is $1,143.55, what is the after tax cost of debt for this firm? (Answer to the nearest tenth of a percent, e.g. 12.3%, but do not use a percent sign).

Answer 1

Information provided:

Par value= future value= $1,000

Current price= present value= $1,143.55

Time= 7 years*2= 14 semi-annual periods

Coupon rate= 4.8%/2= 2.4%

Coupon payment= 0.0240*1,000= $24

Tax rate= 39%

The question is solved by first calculating the before tax cost of debt. The yield to maturity is computed fro that.

Enter the below in a financial calculator to compute the before tax cost of debt:

FV= 1,000

PV= -1,143.55

N= 14

PMT= 24

Press the CPT key and I/Y to compute the yield to maturity.

The value obtained is 1.27.

Therefore, the before tax cost of debt is 1.27%*2= 2.55%.

After tax cost of debt= before tax cost of debt*(1 – tax rate)

                                 = 2.55%*(1 – 0.39)

                                 = 1.6.

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