J&J Manufacturing issued $1,000, 30-year bonds 4 years ago at a coupon rate of 12% compounded semiannually. The bonds are currently selling for $1,150 each. J&J's marginal tax rate is 40%. Calculate cost of debt. (Round to nearest whole percentage)

Question

Quizplus · Accepted Answer

First, we need to find the current yield of the bond: 
Coupon payment = $1,000 x 12% x 0.5 = $60 (since the coupon is paid semiannually) 
Current yield = $60/$1,150 = 5.22%

Next, we need to find the yield to maturity (YTM) using a financial calculator or spreadsheet software.

Using a financial calculator: 
N = 26*2 (since there are 26 coupon payments left, each paid semiannually) 
I/Y = ? 
PV = -$1,150 
PMT = $60 
FV = $1,000 
Solving for I/Y gives us 5.96%.

Using a spreadsheet software, we can use the RATE function: 
RATE(26*2, 60, -1150, 1000) 
This also gives us 5.96%.

Finally, we need to adjust for taxes: 
After-tax cost of debt = YTM x (1 - Marginal Tax Rate) 
= 5.96% x (1 - 0.4) = 3.58%

Rounding to the nearest whole percentage, we get an after-tax cost of debt of 4%.

Therefore, the best choice is B.

J&J Manufacturing Issued $1,000, 30-Year Bonds 4 Years Ago at a Coupon