Question

3. 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.

The required return (or cost) of previously issued debt is often referred to as the      rate. It usually differs from the cost of newly raised financial capital.

Consider the case of Cold Duck Brewing Company:

Cold Duck Brewing Company is considering issuing a new twenty-year debt issue that would pay an annual coupon payment of $90. 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.

Cold Duck’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      from the proceeds the firm will receive after issuing its new bonds. The firm’s marginal federal-plus-state tax rate is 45%.

To see the effect of flotation costs on Cold Duck’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.)

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

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