Question

# The Cost of Debt and Flotation Costs. Suppose a company will issue new 25-year debt with...

The Cost of Debt and Flotation Costs.

Suppose a company will issue new 25-year debt with a par value of \$1,000 and a coupon rate of 10%, paid annually. The issue price will be \$1,000. The tax rate is 35%. If the flotation cost is 5% 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 12% of the bond issue? Round your answer to two decimal places.

Sol:

We are required to calculate Cost of Debt after tax (Kad)

Formula for computation of Cost of debt (Kda) = Interest (1 - tax) / Net proceeds

From the given data we have:

CASE - 1 : Coupon Rate = 10%, Face value of bond = \$1000 , Floatation cost = 5% and Tax rate = 35%

Flotation cost = 1000000* 5% = 50000 \$

Net Proceeds = Debt raised- Flotation cost

= \$1000000 - \$ 50000

= \$ 950000

Therefore Cost of Debt after tax (Kda) = \$1000000*10% (1-.35) / \$950000

= \$65000 / \$950000

= 6.84%

CASE - 2 : Coupon Rate = 10%, Face value of bond = \$1000 , Floatation cost = 12% and Tax rate = 35%

Floatation cost   = \$1000000 * 12% = \$120000

Net Proceeds = Debt raised- Flotation cost

= \$1000000 - \$120000

= \$ 880000

Therefore Cost of Debt after tax (Kda) = \$1000000*10% (1-.35) / \$880000

= \$65000 / \$880000

= 7.39%

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