Question

(45) Costly Corporation plans a new issue of bonds with a par value of $1000, a maturity of 16 years, and an annual coupon rate of 19.0%. Flotation costs associated with a new debt issue would equal 7.0% of the market value of the bonds. Currently, the appropriate discount rate for bonds of firms similar to Costly is 23.0%. The firm's marginal tax rate is 30%. What will the firm's true cost of debt be for this new bond issue?

Answer 1

K = N

Bond Price =∑ [(Annual Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N

k=1

K =16

Bond Price =∑ [(19*1000/100)/(1 + 23/100)^k]     +   1000/(1 + 23/100)^16

k=1

Bond Price = 832.42

Bond proceeds after flotation charge = price*(1-flotation percentage charge)

=832.42*(1-0.07) = 773.229

Effective YTM after considering floatation cost:

K = N

Bond Price =∑ [(Annual Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N

k=1

K =16

773.229 =∑ [(19*1000/100)/(1 + YTM/100)^k]     +   1000/(1 + YTM/100)^16

k=1

YTM = 24.78%

true cost = YTM*(1-tax rate) = 24.78*(1-0.3) = 17.346%