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 25%.What is the component cost of debt for use in the WACC calculation? Do not round your intermediate calculations.

Question

Quizplus · Accepted Answer

To calculate the component cost of debt, first we need to find the yield to maturity (YTM) of the bond. We can use the bond pricing formula to do this:
875 = (35/(1+r)^1) + (35/(1+r)^2) + ... + (35/(1+r)^40) + 1000/(1+r)^20
where r is the semiannual YTM. Solving for r, we get r = 0.081 or 8.10%. However, since interest payments on debt are tax-deductible, we need to adjust this rate by the tax rate:
r(1 - tax rate) = 8.10%(1 - 0.25) = 6.075%
Therefore, the component cost of debt is 2 x 6.075% = 12.15% annually, or 6.075% semiannually, which is closest to 6.22%.

Several Years Ago the Jakob Company Sold a $1,000 Par