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?

Question

Quizplus · Accepted Answer

First, we need to calculate the current yield of the bond, which is the annual coupon payment divided by the current market price:

Annual coupon payment = $1,000 x 7.00% / 2 = $35 
Current yield = $35 / $925 = 3.78%

Next, we need to calculate the after-tax cost of debt using the formula:

After-tax cost of debt = Current yield x (1 - Tax rate)

After-tax cost of debt = 3.78% x (1 - 0.40) = 2.27%

Therefore, the component cost of debt for use in the WACC calculation is 4.54% (2 x 2.27%). 
Alternatively, to get the approximate answer, we can add the current yield to the tax rate multiplied by the current yield:

Approximate cost of debt = Current yield + Tax rate x Current yield 
Approximate cost of debt = 3.78% + 0.40 x 3.78% = 5.03%

The closest answer choice is C, 4.65%.

Lincoln Company Sold a $1,000 Par Value, Noncallable Bond Several