Question

A firm’s capital structure consists of 21% long-term debt. At present, the company can raise debt by selling 17-year bonds with a 11.82% annual coupon interest rate. The firm is in a 32% income tax bracket. Its bonds generally require an average discount of $40.92 per bond and flotation costs of $34.91 per bond when being sold. Required: Calculate the firm’s current after-tax cost of long-term debt.

Answer 1

Let's assume the par value = face value of the bond = $ 1,000 (Such an assumption is customary in debt market and will not impact the final answer)

Market price = Par value - discount = 1,000 - 40.92 = $ 959.08

Net price = Market price - flotation cost = 959.08 - 34.91 = 924.17

YTM can be calculated using the Rate function of excel. Inputs are:

Nper = 17; PMT = Annual coupon = 11.82% x Par value = 11.82% x 1,000 = 118.20; PV = - Net price = - 924.17; FV = Par value = 1,000

Hence, YTM = RATE (Nper, PMT, PV, FV) = RATE (17, 118.20, -924.17, 1000) = 12.94%

Hence, the firm’s current after-tax cost of long-term debt = YTM x (1 - tax rate) = 12.94% x (1 - 32%) = 8.80%