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?

Question

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The component cost of debt for use in the WACC calculation is found by calculating the yield to maturity (YTM) on the bonds, which reflects the after-tax cost of debt. Given that the bonds have a 9.25% annual coupon (paid semiannually), a current price of $1,075, a par value of $1,000, and 20 years to maturity, we can calculate the YTM and then adjust it for taxes. The correct calculation involves finding the interest rate that equates the present value of the bond's future cash flows (coupon payments and the repayment of the par value at maturity) to its current price. After finding the YTM, we adjust it for taxes by multiplying it by (1 - tax rate). However, without performing the detailed calculation here, the correct answer is given as 6.35%, which accounts for the tax adjustment.

Kenny Electric Company's Noncallable Bonds Were Issued Several Years Ago