Question

A company has an outstanding issue of $1,000 face value bonds with a 9.5% annual coupon and 20 years remaining until maturity. The bonds are currently selling at a price of 90 (90% of face value). An investment bank has advised that a new 20-year issue could be sold for a flotation cost of 5% of face value. The company is in the 35% tax bracket.

a. Calculate investors’ required rate of return today.

b. What annual coupon would have to be placed on the new issue in order for it to sell at par?

c. Calculate the flotation cost and tax savings from the proposed new issue.

d. Calculate the cost of the new bond financing.

Answer 1

a. Investors required rate of return = 10.73%

NPER	20
FV	1000.00
PMT	95.00	[1000*9.5%]
PV	900.00
Rate	10.73%	[Rate ( nper, -pmt,pv,-fv)]

b.Annual coupon would have to be placed on the new issue in order for it to sell at par =10.73%

c. Flotation cost = 1000* 5% = 50 per bond

Tax saving from deducting interest = 35% * 107.3= 37.555

Tax saving from flotation cost = 50/ 20* 35% = 0.875

d. cost of the new bond financing = 7.37%

NPER	20
FV	1000.00
PMT	68.87	[107.3-37.555-0.875]
PV	950.00	[1000-50]
Rate	7.37%	[Rate ( nper, -pmt,pv,-fv)]