Question

A corporation has 10,000 bonds outstanding with a 6% annual coupon rate, 8 years to maturity, a $1,000 face value, and a $1,100 market price. The company’s 100,000 shares of preferred stock pay a $3 annual dividend, and sell for $30 per share. The company’s 500,000 shares of common stock sell for $25 per share and have a beta of 1.5. The risk free rate is 4%, and the market return is 12%. Assuming a 21% tax rate, what is the company’s Cost of bonds?

Answer 1

Year Cashflow DF@10% PV DF@3% PV

$ $ $

0 (1,100) 1 (1,100) 1 (1,100)

1-8 47.4 5.3349 252.87 7.0197 332.73

8 1,000 0.4665 465.5 0.7894 789.4

NPV (381.63) NPV 22.13

Kd = LR + NPV1/NPV1+NPV2 x (HR – LR)

Kd = 3 + 22.13/22.13 + 381.63 x (10 – 3)

Kd = 3 + 22.13/403.76 x 7

Kd = 3 + 0.38

Kd = 3.38%

Step-by-step explanation:

Cost of debt is calculated based on internal rate of return formula. In year 0, we will consider the current market price of the bond as cashflow. In year 1 to 8, we will consider the after-tax coupon as the cashflow. The after-tax coupon is calculated as R(1 - T). R is 6% x $1,000 = $60 and tax is 21%. Thus, we have $60(1 - 0.21) = $47.4. then we will discount the cashflows for 8 years so as to obtain the internal rate of return. The internal rate of return represents cost of debt.