Question

9. Lee Airlines plans to issue 15-year bonds with a par value of $1,000 that will pay $50 every six months. The bonds have a market price of $920. Flotation costs on new debt will be 6%. If the firm is in the 35% marginal tax bracket, what is the posttax cost of new debt?

Answer 1

Answer-

Given

Floation costs on new debt = F = 6 % = 0.06
Considering the flotation cost we need to calculate all the values

N = Number of years = 15 x 2 = 30 [ Semi annual payments ]
Present value = Markeg value = PV = $ 920
Adjusting PV for flotation costs = $ 920 x ( 1 - F) = $ 920 x ( 1 - 0.06) = $ 920 x 0.94 = $ 864.8
Future value = Par Value = $ 1000
Payment = PMT = $ 50
Tax rate = 35 % = 0.35

Substituting all the value in finnancial calculator
PV = $ 864.8
FV = $ 1000
N = 30
PMT = $ 50
Pre tax cost of debt = I/Y = ?
Pre tax cost of debt = I /Y = 5.98 %

Post tax cost of debt = 5.98 % x ( 1 - tax rate )
= 5.98 % x ( 1 - 0.35 )
= 5.98 % x 0.65
= 3.89 %

Post tax cost of debt = 3.98 %