Question

To help finance a major expansion, Castro Chemical Company sold a noncallable bond several years ago that now has 20 years to maturity. This bond has a 9.25% annual coupon, paid semiannually, sells at a price of $1,025, and has a par value of $1,000. If the firm's tax rate is 40%, what is the component cost of debt for use in the WACC calculation? Do not round your intermediate calculations.a. 5.39%b. 6.09%c. 5.93%d. 5.93%e. 4.69%

Answer 1

Answer:

a. 5.39%

Explanation:

This question is asking for the after-tax cost of debt ;which is the YTM

Using a financial calculator, enter the following and adjust the time, and coupon payments to semiannual basis;

Maturity of the bond ; N = 20*2 = 40

Face value; FV = 1000

Price; PV  = -1,025

Semiannual coupon payment; PMT = (9.25%/2)*1000 =  46.25

then compute semiannual interest rate; CPT I/Y = 4.489%

YTM (Pretax cost of debt ) = 4.489% *2 = 8.98%

WACC uses the aftertax cost of debt;

aftertax cost of debt = pretax cost of debt (1-tax)

= 8.98% *(1-0.4)

= 5.388%

Therefore, the component cost of debt for use in the WACC calculation is 5.39%