Question

Garden Industries can sell 15-year, $1,000 par value bonds paying annual interest at a 12% coupon rate. The bonds can be sold for $1010 each, flotation costs of $25 per bond. The firm is in the 40% tax bracket.

​a. Find the net proceeds from sale of the bond Nd

​b. Calculate the before-tax and after-tax costs of debt.

Answer 1

​a. Find the net proceeds from sale of the bond Nd=

Selling price-Flotation cost per bond

ie. 1010-25=

985

(Answer)

​b. Before-tax and after-tax costs of debt.

using the formula to find the present value,ie.current market Price of bonds,

Price/PV =PV of its future cash flows=PV of all its future coupon cash flows+PV of face value to be received at maturity----both discounted at the Yield or YTM--which is the before-tax cost of the bond

ie. Price /PV =(Pmt.*(1-(1+r)^-n)/r)+(FV/(1+r)^n)

where, price /PV net proceeds from sale of the bonds= $ 985 --as found in a. above

Pmt.= The annual   coupon in $ , Par value*coupon % ie. 1000*12%= $ 120

r= the   annual Yield or YTM /before-tax annual cost of the bond--- to be found out---??

n= no.of coupon (annual)period still to maturity, ie. 15

FV= face value, ie. $ 1000

So, plugging in these values in the formula,

ie.985=(120*(1-(1+r)^-15)/r)+(1000/(1+r)^15)

Solving the above for r, we get the before-tax semi-annual cost of the bond as

12.2229%

So, the annual before-tax cost=

12.22%

(Answer)

now the after-tax annual cost of the bond, kd==

Before tax cost*(1-Tax rate)

ie.12.2229%*(1-40%)=

7.33%

(Answer)