Question

Costly Corporation plans a new issue of bonds with a par value of $1000, a maturity of 37 years, and an annual coupon rate of 11.0%. Flotation costs associated with a new debt issue would equal 3.0% of the market value of the bonds. Currently, the appropriate discount rate for bonds of firms similar to Costly is 9.0%. The firm's marginal tax rate is 50%. What will the firm's true cost of debt be for this new bond issue?

	11.34%
	9.29%
	4.65%
	5.67%
	12.74%

Costly Corporation is considering using equity financing. Currently, the firm's stock is selling for $71.00 per share. The firm's dividend for next year is expected to be $4.10 with an annual growth rate of 8.0% thereafter indefinitely. If the firm issues new stock, the flotation costs would equal 15.0% of the stock's market value. The firm's marginal tax rate is 40%. What is the firm's cost of internal equity?

	12.99%
	14.79%
	14.24%
	15.34%
	13.77%

Answer 1

1.
Calculation of bond price:
FV = 1000
Nper = 37
PMT = 1000 * 11% = 110
Rate = 9%

Price of bond can be calculated by using the following excel formula:
=PV(rate,nper,pmt,fv)
=PV(9%,37,-110,-1000)
= $1,213.06

Price of bond after flotation = $1,213.06 * (1 - 0.03) = $1,176.67

Calculation of new cost of debt:
FV = 1000
PV = 1176.67
Nper = 37
PMT = 110

Cost of debt can be calculated by using the following excel formula:
=RATE(nper,pmt,pv,fv)
=RATE(37,110,-1176.67,1000)
= 9.29%

New cost of debt = 9.29%

New after tax cost of debt = 9.29% * (1 - 0.50) = 4.65%

2.
Cost of equity = D1 / (P0 * (1 - F) +g
= $4.10 / ($71 * (1 - 0.15) + 0.08
= $4.10 / $60.35 + 0.08
= 0.0679 + 0.08
= 14.79%

Cost of equity = 14.79%