Question

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.
  

Answer 1

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%