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 that is to be raised to finance the new project.

Consider the case of Cold Duck Brewing Company y:

Cold Duck Brewing Company can issue a 15-year debt security that pays an annual coupon payment of $75. The bond carries a par value of $1,000 and is currently trading at par. Based on this information, determine the after-tax cost of Cold Duck's debt if the firm’s marginal federal-plus-state tax rate is 40%.

Cold Duck Brewing Company y's after-tax cost of debt (rounded to four decimal places) is:

1)            4.9500 %

2)            3.6000 %

3)            4.7250%

4)            4.5000%

5) Cold Duck's CFO has pointed out that if these new bonds are issued, the company will incur a flotation cost of 2%. Remember, these flotation costs will be __________ from the proceeds the firm receives from the sale of its new bonds. Calculate the company's after-tax cost of debt net of the issue’s flotation costs.

If Cold Duck issues its new bonds and incurs flotation costs of 2%, then its adjusted (net) after-tax cost of debt (rounded to four decimal places) will be:

1)            4.9500%

2)            4.2750 %

3)            4.6379%

4)            4.0500%

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

Answer 1

Answer a.

Par Value = $1,000
Current Price = $1,000
Annual Coupon = $75
Time to Maturity = 15 years

Par Value is equal to Current Price, so, Annual YTM is equal to Annual Coupon Rate

Annual Coupon Rate = Annual Coupon / Par Value
Annual Coupon Rate = $75 / $1,000
Annual Coupon Rate = 7.50%

Annual YTM = 7.50%

Before-tax Cost of Debt = 7.5000%
After-tax Cost of Debt = 7.5000%*(1 - 0.40)
After-tax Cost of Debt = 4.5000%

Answer b.

Cold Duck's CFO has pointed out that if these new bonds are issued, the company will incur a flotation cost of 2%. Remember, these flotation costs will be deducted from the proceeds the firm receives from the sale of its new bonds.
Answer c.

Par Value = $1,000

Current Price = $1,000
Flotation Cost = 2%*$1,000 = $20
Net Proceed from Sale = $1,000 - $20 = $980

Annual Coupon = $75
Time to Maturity = 15 years

Let Annual YTM be i%

$980 = $75 * PVIFA(i%, 15) + $1,000 * PVIF(i%, 15)

Using financial calculator:
N = 15
PV = -980
PMT = 75
FV = 1000

I/Y = 7.73%

Before-tax Cost of Debt = 7.7298%

After-tax Cost of Debt = 7.7298%*(1 - 0.40)
After-tax Cost of Debt = 4.6379%

Answer d.

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