1. Although it has considered raising debt capital in Europe, PNC has actually r

Question

1. Although it has considered raising debt capital in Europe, PNC has actually raised all of its capital in the U.S. Based on the data in Table 1-a, what is a reasonable estimate of the com- pany’s cost of debt for use in the WACC calculation? What do the results imply about the slope of PNC’s yield curve? Please use data below

Two dollar-denominated bonds are currently outstanding. Bond A has a 6.75 percent semiannual coupon, sells for 88.75 percent of par, matures on July 1, 2029, and can be called at a price of 105 on July 1, 2009. Bond B has a 9.0 percent semiannual coupon, sells for 112.25 percent of par, also matures on July 1, 2029, and can be called at a price of

107.50 on July 1, 2009. PNC’s federal-plus-state tax rate is 40 percent. Assume that the analysis is conducted on September 15, 2004, and use this as the settlement date, i.e., the day the bond will be purchased. New bonds carrying the prevailing rate could be sold to institutional investors, and no bond flotation cost would be involved.

Explanation / Answer

Part A)

In the given case, we will have to calculate the YTM (yield to maturity) and YTC (yield to call) of both the bonds in order to determine the cost of debt for the company. Both YTM and YTC can be calculated with the use of Rate function/formula of EXCEL/Financial Calculator. The function/formula for Rate is Rate(Nper,PMT,-PV,FV) where Nper = Period, PMT = Coupon Payment, PV = Current Price of Bonds and FV = Face Value/Call Price.

____________

Bond A:

YTM:

Here, Nper = 25*2 = 50, PMT = 1,000*6.75%*1/2 = $33.75, PV = 1,000*88.75% = $887.50 and FV = $1,000 [we use 2, since the bond is semi-annual]

Using these values in the above function/formula for Rate, we get,

YTM = Rate(50,33.75,-887.50,1000)*2 = 7.78%

____________

YTC:

Here, Nper = 5*2 = 10, PMT = 1,000*6.75%*1/2 = $33.75, PV = 1,000*88.75% = $887.50 and FV = 1,000*105%= $1,050 [we use 2, since the bond is semi-annual]

Using these values in the above function/formula for Rate, we get,

YTC = Rate(10,33.75,-887.50,1050)*2 = 10.48%

____________

Bond B:

YTM:

Here, Nper = 25*2 = 50, PMT = 1,000*9%*1/2 = $45, PV = 1,000*112.25% = $1,122.50 and FV = $1,000 [we use 2, since the bond is semi-annual]

Using these values in the above function/formula for Rate, we get,

YTM = Rate(50,45,-1122.50,1000)*2 = 7.87%

____________

YTC:

Here, Nper = 5*2 = 10, PMT = 1,000*9%*1/2 = $45, PV = 1,000*112.25% = $1,122.50 and FV = 1,000*107.50%= $1,075 [we use 2, since the bond is semi-annual]

Using these values in the above function/formula for Rate, we get,

YTC = Rate(10,45,-1122.50,1075)*2 = 7.30%

____________

Since, the company has the option to call the bonds, we will take the lower of YTM and YTC to determine the after-tax cost of debt. As evident from the above calculations, the YTC of Bond B is lower than its YTM, so company would retire those bonds. The cost of debt (both before and after) has been calculated as below:

Before-Tax Cost of Debt = (YTM of Bond A + YTC of Bond B)/2 = (7.78% + 7.30%)/2 = 7.54%

After-Tax Cost of Debt = Before-Tax Cost of Debt*(1-Tax Rate) = 7.54%*(1-40%) = 4.52%

Therefore, the company's cost of debt to be used in WACC calculation is 4.52%

____________

Part B)

The slope of the yield curve based on the above calculations would indicate that the rate of return on short-term and long term-bonds are almost equal to each other. This means that the risk associated with long term bonds is low and the company is more or less stable both in the short run and in the long run.

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