Two years ago, a company issued $20 million in long-term bonds at par value with a coupon
rate of 9 percent. The company has decided to issue an additional $20 million in bonds and
expects the new issue to be priced at par value with a coupon rate of 7 percent. The company
has no other debt outstanding and has a tax rate of 40 percent. To compute the company's
weighted average cost of capital, the appropriate after-tax cost of debt is closest to:
A. 4.2%.
B. 4.8%.
C. 5.4%.
Solution: A
The relevant cost is the marginal cost of debt. The before-tax marginal cost of debt can be
estimated by the yield to maturity on a comparable outstanding.
After adjusting for tax, the after-tax cost is 7(1- 0.4) = 7(0.6) = 4.2%.
