Question

The market price of a bond is $1129 (Face Value = 1000). It has 14 years to maturity and pays an annual coupon of $100 in semi-annual installments. What is the effective annual cost of debenture capital before tax (kd)?

Please help to explain how to do this, should I use D1/P0 + G? *but i couldnt figure out the growth rate.

Answer 1

The before tax cost of capital of debenture capital is the

YTM (Yield to maturity) of the debenture.

The YTM is the internal rate of return of the cash flows

associated with the debenture.

The cash flows from the bond are:

*Outflow, being the market price of the bond of $1129.

*The inflow would consist of the MV of $1000 and the

semi-annual coupons of $50.

The YTM is that discount rate which equates the price

of the debenture of $1129 with the PV of the Maturity value

and the PV of the semi annual interest payments.

Hence,

1129 = 1000*PVIF(r,28)+50*PVIFA(r,28)

The value of r (YTM/2) is to be found by trial and error or by

using a financial calculator.

Using a financial calculator YTM = 8.41%