Question

The Lincoln Company sold a $1,000 par value, noncallable bond several years ago that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $925 and the company's tax rate is 40%. What is the component cost of debt for use in the WACC calculation?

Answer 1

First we have find the before tax cost of debt and can be calculated using RATE function in EXCEL

=RATE(nper,pmt,pv,fv,type)

Here the payments are semi-annual

nper=2*20=40   

pmt=semi-annual coupon payment=(7%*1000)/2=35

pv=925

fv=1000

=RATE(40,35,-925,1000,0)=3.87%

RATE=Semi-annual yield=3.87%

Annual yield=before tax cost of debt=2*3.87%=7.74%

After tax cost of debt=Before tax cost of debt*(1-tax rate)=7.74%*(1-40%)=4.65%

The cost of debt component is 4.65% that need to be used for WACC calculation