Question

Happy Lion Manufacturing is considering issuing a new twenty-year debt issue that would pay an annual coupon payment of $90. Each bond in the issue would carry a $1,000 par value and would be expected to be sold for a market price equal to its par value.

Happy Lion’s CFO has pointed out that the firm will incur a flotation cost of 2% when initially issuing the bond issue. Remember, these flotation costs will be subtracted    from the proceeds the firm will receive after issuing its new bonds. The firm’s marginal federal-plus-state tax rate is 45%.

To see the effect of flotation costs on Happy Lion’s after-tax cost of debt, calculate the before-tax and after-tax costs of the firm’s debt issue with and without its flotation costs, and insert the correct costs into the boxes. (Note: Round your answer to two decimal places.)

Before-tax cost of debt without flotation cost:	%
After-tax cost of debt without flotation cost:	%
Before-tax cost of debt with flotation cost:	%
After-tax cost of debt with flotation cost:	%

Answer 1

Without flotation cost:

Before-tax cost of debt without flotation cost = 9%

After-tax cost of debt without flotation cost = 4.95% [9%*(1-45%)]

With flotation cost: