Question

1). Peyton’s Colt Farm just issued 7% semiannual coupon bonds with 30 years to maturity and a face value of $1000. The bonds sell for 94% of par value and the company’s tax rate is 35%. What is the pre-tax cost of debt? Show calculations

2)Rainbow in the Dark Manufacturing uses only debt and equity in its capital structure and has a target debt to equity ratio of 0.65. Its cost of equity is 13%, and its pretax cost of debt is 8%. If the tax rate is 35%, what is the company’s WACC? Show calculations

Answer 1

Answer 1.) Calculation of Pre tax cost of Debt :

Pre tax cost of Debt can be calculated using Rate Function of Excel :

Using Financial Calculator

=RATE(nper,pmt,pv,fv)

where nper is Number of years to maturity i.e 30 * 2 = 60 (Multiplied by 2 As coupons are paid semiannually)

pmt is Interest payment i.e 1000 * 7% = 70 / 2 = 35 (Divided by 2 As coupons are paid semiannually)

pv is Current Market Price

= 940 (1000 * 94%)

Note : pv should be taken as negative.

fv is face value i.e 1000

=RATE(60,35,-940,1000)

therefore ,Pretax cost of debt is 3.75290%(Semiannual)

Pretax cost of Debt is 3.75290%* 2 = 7.51%(Annual)

Answer : 2 ) Calculation of WACC

WACC = (Cost of Equity * Weight of Equity) + (Cost of after tax debt * Weight of Debt)

Weight of Equity = 1/(1 + 0.65)

Weight of Debt = 0.65 / (1 + 0.65)

WACC = [13% * (1 / 1.65)] +[8% * (1 - 0.35) * (0.65 / 1.65)]

= 7.878788% + 2.04848%

= 9.93%