Question

The cost of debt capital The cost of debt that is relevant when companies are evaluating new investment projects is the marginal cost of the new debt that is to be raised to finance the new project. rate. It usually differs from the average cost of the required return (or cost) of newly-issued debt is often referred to as the financial capital raised by a firm in the past. Consider the case of Purple Lemon Shipbuilders: Purple Lemon Shipbuilders is considering issuing a new twenty-five-year debt issue that would pay an annual coupon payment of $75. Each bond in the issue would carry a $1,000 par value and would be expected to be sold for a market price equal to its par value. Purple Lemon's CFO has pointed out that the firm will incur a flotation cost of 2% when initially issuing the bond issue. Remember, these flotation costs will be 30%. from the proceeds, the firm will receive after issuing its new bonds. The firm's marginal federal-plus-state tax rate is To see the effect of flotation costs on Purple Lemon's after-tax cost of debt, calculate the before-tax and after-tax costs of the firm's debt issue with and without its flotation costs, and insert the correct costs into the boxes. (Note: Round your answer to two decimal places.) The before-tax cost of debt without flotation cost: After-tax cost of debt without flotation cost: Before-tax cost of debt with flotation cost: After-tax cost of debt with flotation cost:

Answer 1

Answer:

Since the market value equals face value,coupon rate =yield is 75/1000=7.5%

That is 7.5% is before tax cost of floating the bonds

At tax rate of 30%,after tax cost of floating bond =7.5%*(1-30%)=5.25%

However,with a flotation cost of 2%,the before tax cost of flotation is calculated  using below formula found in the explanation section.

((75+(1000-980)/25)/(980+1000)*2)=7.66%

Since tax rate remains 30%,the after tax cost  of floating the bond with floating cost of 2% is: 7.66%*(1-30%)=5.36%  

Explanation:

(Interest payment+((Par value-Net Proceds Value)/number of yr)/(Net Proceds+Par value)/2