Question

A firm has issued $20 million in long-term bonds that now have 10 years remaining until maturity. The bonds carry an 8% annual coupon and are selling in the market for $877.10. The firm also has $45 million in market value of common stock. For cost of capital purposes, what portion of the firm is debt financed and what is the after-tax cost of debt, if the tax rate is 35%?

Answer 1

a. The total number of bonds issued=Total value/Face value=$20,000,000/$1000=20,000

Market value of debt=Total number of bonds*market price=20,000*$877.10=$17,542,000

Total Value=Market value of debt+Market value of equity=$17,542,000+$45,000,000=$62,542,000

Portion of debt financed=Market value of debt/Total value=$17,542,000/$62,542,000=28.05%

b. Before tax cost of debt has to be found using RATE function in EXCEL

=RATE(nper,pmt,pv,fv,type)

nper=maturity time=10

pmt=annual coupon=(coupon rate*face value)=(8%*1000)=80

pv=877.1

fv=1000

=RATE(10,80,-877.1,1000,0)

RATE=10%

Before tax cost of debt=10%

After tax cost of debt=Before tax cost of debt*(1-tax rate)=10%*(1-35%)=6.5%