CFA Practice Question

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CFA Practice Question

A company is determining the cost of debt for use in its weighted average cost of capital. It has recently issued a 10-year, 6 percent semi-annual coupon bond for $864. The bond has a maturity value of $1,000. If the marginal tax rate is 35 percent, the cost of debt (%) the company should use in its calculation is closest to ______.

A. 2.6
B. 3.8
C. 5.2
Correct Answer: C

The pre-tax cost of debt is the YTM of the bond. To calculate the YTM of the bond:
Using a financial calculator, enter N=20, PV=-864, PMT=30, and FV=1,000. Compute I/YR. The result (4%) is the semi-annual rate; double it to get the annual rate (8%). This is the pre-tax cost of debt. Multiplying the pre-tax cost of debt by 1 - tax rate gives the result: 5.2% (8 * 0.65 = 5.2).

Note: because the bond pays coupons semi-annually, there are 20 periods (10 years times two payments per year) and the periodic coupon payment is $30 (6% of $1,000 per year paid in two equal payments every six months).

User Contributed Comments 3

User Comment
dvallejo please anybody could say me how to compute I/YR in the financial calculator Texas instrument BAII Plus
jazzguitar Exactly as indicated in the question, typing N=20, PV=-864, PMT=30, and FV=1,000 and then computing I/Y
Logaritmus Why bother to calculate? Just use logic. If the bond will be issued at par we have answear B (thus automatically eliminate A), but we have a huge discount, so we are able to eliminate B too. Therefore C is a proper answear.
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