The Weighted Average Cost of Capital
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guideline_for_question_c.docxHere is a guideline for answering (c) in Assignment 2 this week.
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C. The company will use new bonds for any capital project, according to the capital structure. These bonds will have a market and par value of $1000, with a coupon rate of 4% and a flotation cost of 6%. The bonds will mature in 30 years and no other debt will be used for any new investments. The corporate tax rate is 40%. What is the cost of new debt? What are the advantages and disadvantages of issuing new debt in the capital structure? |
There is no formula that can be used to calculate the exact yield to maturity for a bond (except for trivial cases). Instead, the calculation must be done on a trial-and-error basis. This can be tedious to do by hand. Fortunately, the HP 10B calculator has the time value of money keys, which can do the calculation quite easily. Technically, you could also use the IRR function, but there is no need to do that when the TVM keys are easier and will give the same answer. You can also use Excel.
To calculate the YTM, just enter the bond data into the TVM keys in a calculator such as HP 10B. We can find the YTM by solving for I/YR. Set I/YR for 1 (annual payments). Enter 30 into N, -940 into PV, 40 into PMT, and 1,000 into FV. Now, press I/YR and you should find that the YTM is 4.362%.
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C. Calculator Solution: N= 30 PV= -940, PMT=40, FV= 1000 Before tax cost of debt = 4.362% After Tax cost of debt = .04362(1-Tax rate) = .04362(1-.40) YTM = 2.62% |
Interest costs are tax deductible for a company. Therefore the true cost of debt = [Yield-to-maturity of a bond YTM) x (1 - tax rate)]. The PV is (price of $1,000 - flotation cost percentage). Since flotation cost was 6%, it was 0.06 x $1,000 = $60. So PV = 940, it is shown as a negative since the price represents a payment.
The face value of a bond is always $1,000. The reason the price is $1,000 in this case is that it states the bond has a market price equal to par meaning face value. However, the company only receives $940 for each new bond it issues because of flotation or selling costs.
The PMT amount or interest received each year = coupon rate x $1,000 = 4% x $1,000 = $40. FV is the face value of $1,000. The procedure for bond price calculation is always the same, only the numbers change.
For advantages and disadvantages of new debt, check text readings and lecture notes. Use your own words in the assignment and show citation and reference for textbook.
