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Endrun Corporation has exist1,000 par value bonds currently selling for exist980. The bonds have a coupon rate of 10% and are paying interest semiannually. The bonds are due to reach maturity in 15 years. If Endrun’s tax rate is 40%. What cost of debt should be used in arriving at the firm’s weighted average cost of capital? Select one: A. 4.10% B. 6.16% C. 8.95% D. 10.26%
Expert Answer
Bond price P0 = C* [1- 1/ (1+i) ^n] /i + M / (1+i) ^n
Where
Price of the bond P0 = Selling price = $980
C = coupon payment = 10%/2 of $1000 = $50 semiannual coupon
n = number of payments = 15 years *2 = 30
i = interest rate, or yield to maturity =?
M = value at maturity, or par value = $ 1000
Therefore,
$ 980 = $ 50 * [1 – 1 / (1+i) ^30] /i + 1000 / (1+i) ^30
By trial and error method we got the value of i = 5.13%
Or annual rate I = 5.13% *2 = 10.26%
Tax rate of Endrun Corporation is 40%
Cost of debt used for weighted average cost of capital is after tax cost of debt
After tax cost of debt = 10.26% * (1- 40%)
= 10.26% * 0.60
= 6.16%
Therefore correct answer is option B. 6.16%.
