Question

Kenny Electric Company's noncallable bonds were issued several years ago and now have 20 years to maturity. These bonds have a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. If the firm's tax rate is 25%, what is the component cost of debt for use in the WACC calculation?

a. 6.67%

b. 6.03%

c. 5.73%

d. 5.44%

e. 6.35%

Answer 1

Information provided:

Face value= future value= $1,000

Market price= present value= $1,075

Time= 20 years*2= 40 semi-annual periods

Coupon rate= 9.25%/2= 4.6250%

Coupon payment= 0.046250*1,000= $46.25

The before tax cost of debt which is used in the computation of the component cost of debt.

The before tax cost of debt is calculated by computing the yield to maturity.

The yield to maturity is calculated by entering the below in a financial calculator:

FV= 1,000

PV= -1,075

N= 40

PMT= 46.25

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

The value obtained is 4.2328.

Therefore, the yield to maturity is 4.2328%*2= 8.4657%.

Computation of the component cost of debt= before tax cost of debt*(1 - tax rate)

= 8.4657%*(1 - 0.25)

= 6.3493% 6.35%.

Hence, the answer is option e.