Cost of debt using both methods (YTM and the approximation formula) Currently, W
ID: 2791775 • Letter: C
Question
Cost of debt using both methods (YTM and the approximation formula) Currently, Warren Industries can sell 10-year, $1,000-par-value bonds paying annual interest at a 9% coupon rate. As a result of current interest rates, the bonds can be sold for $1,010 each before incurring flotation costs of $30 per bond. The firm is in the 30% tax bracket. a. Find the net proceeds from the sale of the bond, N b. Calculate the bond's yield to maturity (YTM) to estimate the before-tax and after-tax costs of debt. c. Use the approximation formula to estimate the before-tax and after-tax costs of debt.Explanation / Answer
a) Net proceeds = 1010 - 30 = $980
b) YTM can be calculated using I/Y function
N = 10, PMT = 9% x 1000 = 90, PV = -980, FV = 1000 => Compute I/Y = 9.32% is the YTM and before-tax cost of debt
After-tax cost of debt = Before-tax cost of debt x (1 - tax rate) = 9.32% x (1 - 30%) = 6.52%
c) Approx YTM = C + (F - P)/n / (F + P) / 2 = 90 + (1000 - 980)/10 / (1000 + 980)/2 = 9.29% is the YTM and before-tax cost of debt
After-tax cost of debt = 9.29% x (1 - 30%) = 6.51%