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 35%. The firm's bonds pay interest semiannually with a 7.1% coupon rate and have a maturity of 13 years. If the current price of the bonds is $934.64, 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:

Face value= $1,000

Coupon rate= 7.1%/2= 3.55%

Coupon payment= 0.0355*1,000= $35.50

Time= 13 years*2= 26 semi-annual periods

Current price= present value= $934.64

The after tax cost of debt is calculated by first calculating the before tax cost of debt.

Enter the below in a financial calculator to calculate the yield to maturity:

FV= 1,000

PV= -934.64

N= 26

PMT= 35.50

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

The value obtained is 3.9570.

Therefore, the before tax cost of debt is 3.9570%*2= 7.9141%

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

                                        = 7.9141%*(1 – 0.35)

                                        = 5.1441%5.1%.

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