Question

3. The cost of debt

What do lenders require, and what kind of debt costs the company?

The cost of debt that is relevant when companies are evaluating new investment projects is the marginal cost of the new debt to be raised to finance the new project.

Consider the case of Red Oyster Seafood Company (Red Oyster):

Red Oyster Seafood Company is considering issuing a new 20-year debt issue that would pay an annual coupon payment of $70. Each bond in the issue would carry a $1,000 par value and would be expected to be sold for a price equal to its par value.

Red Oyster’s CFO has pointed out that the firm would incur a flotation cost of 1% when initially issuing the bond issue. Remember, the flotation costs will besubtracted 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 Red Oyster’s 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 costs (in percentage form):

After-tax cost of debt without flotation cost:	3.8500%
After-tax cost of debt with flotation cost:

This is the cost ofmarginal   debt, and it is different from the average cost of capital raised in the past.

Answer 1