Question

Several years ago the Jakob Company sold a $1,000 par value, noncallable bond that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $875, and the company’s tax rate is 40%. What is the component cost of debt for use in the WACC calculation? Do not round your intermediate calculations.

Answer 1

Answer:

= 4.98%

Explanation:

WACC = wE*rE + wD*rd(1-tax)

wE = weight of equity

rE= cost of equity

wD = weight of debt

rd = pretax cost of debt ; a.k.a Yield to maturity(YTM)

WACC uses the after tax cost of debt in its calculation. This is because interest rate paid on debt is tax deductible unlike dividends.

In the above formula, " rd(1-tax) "  is the calculation for after tax cost of debt. In this case, you have noncallable bond whose Yield to maturity (YTM) will be the Pretax cost of debt.

Using a financial calculator, you can find the YTM with the following inputs;

N; time to maturity = 20

FV; Face value = 1,000

PV; bond price = -875

PMT; coupon payment = 7%*1000 = 70

then CPT I/Y = 8.302%

Using this component "rd(1-tax)" of WACC,

After tax cost of debt = 8.302%(1-0.4)

= 4.98%