The 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

The component cost of debt is the yield to maturity (YTM) on the bond, adjusted for taxes. The bond's YTM can be calculated using the bond's current price, coupon rate, and time to maturity. The semiannual coupon is $35 (7% of $1,000 divided by 2), and the bond has 40 periods (20 years x 2). Solving for YTM using these inputs gives approximately 4.65% annually. After-tax cost of debt = YTM * (1 - tax rate) = 4.65% * (1 - 0.40) = 2.79%. However, the question asks for the pre-tax cost, which is 4.65%.

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