Question

Sample company is considering issuing a new 20 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 price equal to it par value.

Sample point out that the firm would incur a floatation cost of 2% when initially issuing the bond issue. Remember, the flotation cost will be --------- (subtracted or added) from the proceeds the firm will receive after issuing its new bonds. The firm marginal federal plus state rate is 45%.

To see the effect of the flotation cost Sample after tax cost of debt (generic) , calculate the after tax cost of the firm's debt issue with and without its flotation costs, and select the correct after tax cost from the following

after tax cost of debt without flotation cost

after tax cost of debt with flotation cost

this is the cost of ------ (new or embedded) debt and its is different from the average cost of capital raised in the past.

Answer 1

Coupon rate = ( 90 / 1000 ) * 100

Coupon rate = 9%

Since price is equal to par value, coupon rate will be equal to YTM

Before tax cost of debt = 9%

After tax cost of debt = 0.09 ( 1 - 0.45)

After tax cost of debt without flotation cost = 0.0495 or 4.95%

Price with flotation cost = 1000 ( 1 - 0.02)

Price with flotation cost = $980

Before tax cost of debt using a financial calculator = 9.22%

Keys to use in a financial calculator: PV = -980, FV = 1000, PMT = 90, N = 20, CPT I/Y

After tax cost of debt = 0.0922 ( 1 - 0.45)

After tax cost of debt with flotation cost = 0.05071 or 5.071%