Question

You are required to use a financial calculator or spreadsheet (Excel) to solve 10 problems related to the cost of capital. You are required to show the following 3 steps for each problem: (i) Describe and interpret the assumptions related to the problem. (ii) Apply the appropriate mathematical model to solve the problem. (iii) Calculate the correct solution to the problem. Round all answers to two decimal places.

Lee Airlines plans to issue 25-year bonds with a par value of $1,000 that will pay $40 every six months. The bonds have a market price of $970. Flotation costs on new debt will be 6%. If the firm is in the 35% marginal tax bracket, what is cost of new debt?

Answer 1

Redemption price (face value) of bond	1000
Market price of bond	970
Flotation cost	6%	=6%*1000
Flotation cost	60
Income from bond for Lee	910	=970-60
Coupon payment	40
Coupon frequency	Semi-annual
Yearly coupon payment	80
Coupon rate	8%	=80/1000
Maturity (years)	25
Maturity date	4/5/2044
Settlement date	4/5/2019
Yield	8.90%	=YIELD(4/5/19,4/5/44,8%,910,1000,2(semiannual),1)
Pre-tax cost of debt for Lee	8.90%
Tax rate	35%
Post-tax cost of debt for Lee	5.79%	=9.11*(1-35%)

Lee gets to deduct the interest payments from taxable income. Hence, the cost of debt for them is the after tax cost of debt. Pre tax cost of debt is the yield on the bonds as this is the effective rate applicable for Lee. Notice that the yield is higher than coupon rate as Lee does not receive 100% of face value from the bond floatation. It receives only the market price of the bond less the flotation cost. Another way of calculating yield is to calculate IRR for 25 year period where- initial payment is the income from bond floatation, period payments are the semi-annual coupons, and the terminal value is face value. The initial payment should be marked as -ve here as this is income while coupon and principal repayment are expenses. The IRR obtained this way is the semi-annual IRR and needs to be multiplied by 2 to get the annual yield