Question

Suppose a company will issue new 20-year debt with a par value of $1,000 and a coupon rate of 8%, paid annually. The issue price will be $1,000. The tax rate is 35%. If the flotation cost is 2% of the issue proceeds, then what is the after-tax cost of debt? Disregard the tax shield from the amortization of flotation costs. Round your answer to two decimal places. % What if the flotation costs were 11% of the bond issue? Round your answer to two decimal places. %

Answer 1

Answer:

if the flotation costs were 2%, the after-tax cost of debt is 5.10%

if the flotation costs were 11%, the after-tax cost of debt is 4.63 %

Explanation:

After-tax cost of debt = Market Interest × ( 1 - tax rate)

Calculation of the Market Interest

Hint : Use the time value of money principles

Pv = -$1,000

Pmt = $1,000 × 8 % = $80

P/yr = 1

N = 20

Fv = $1,000

YTM = ?

Using a financial calculator, the market interest is 8%

After-tax cost of debt = Market Interest × ( 1 - tax rate)

                                   = 0.08 × (1- 0.35)

                                   = 0.052 or 5.20 %

If Flotation cost is 2%

Net Receipts after flotation cost = Cost × ( 1 - flotation rate)

                                                     = 5.20 % × (1-0.02)

                                                     = 5.096 % or 5.10% (two decimal places)

If Flotation cost is 11%

Net Receipts after flotation cost = Cost × ( 1 - flotation rate)

                                                     = 5.20 % × (1-0.11)

                                                     = 4.628 % or 4.63 % (two decimal places)