Question

For which capital component must you make a tax adjustment when calculating a firm’s weighted average cost of capital (WACC)? Preferred stock Debt Equity Water and Power Company (WPC) can borrow funds at an interest rate of 9.70% for a period of five years. Its marginal federal-plus-state tax rate is 25%. WPC’s after-tax cost of debt is (rounded to two decimal places). At the present time, Water and Power Company (WPC) has 15-year noncallable bonds with a face value of $1,000 that are outstanding. These bonds have a current market price of $1,555.38 per bond, carry a coupon rate of 11%, and distribute annual coupon payments. The company incurs a federal-plus-state tax rate of 25%. If WPC wants to issue new debt, what would be a reasonable estimate for its after-tax cost of debt (rounded to two decimal places)? (Note: Round your YTM rate to two decimal place.) 4.11% 4.73% 4.93% 3.70%

Answer 1

Answer and Explanation:

In order to make the adjustment for tax for determining the weighted average cost of capital , the debt component should be used as the interest expense is to be considered as deductible due to which the tax impact would be decreased

The after tax cost of debt is

= Cost of debt × (1 - tax rate)

= 9.70% × (1 - 0.25)

= 7.28%

Now the ytm would be

Given that

Future value = $1,000

Present value = $1,555.38

NPER = 15%

PMT = $1,000 ×11% = $110

The formula is given below:

= RATE(NPER;PMT;-PV;FV)

The present value comes in negative

After applying the above formula, the yield to maturity is 5.4759%

Now the after tax cost of debt is

= 5.4759% × (1 - 0.25)

= 4.11%