1. A bond has a $1,000 par value (face value) and a contract or coupon interior rate of 8%. A new issue would have a flotation cost of 5% of the market value. The bonds mature in 10 years. The firm’s average tax rate is 28% and its marginal tax rate is 39%. The current price is $1100. What is the after tax cost of debt?
To calculate the after-tax cost of debt, you need to consider both the coupon rate and the flotation cost while taking into account the firm's tax rates.
Step 1: Determine the flotation cost.
The flotation cost is 5% of the market value. Since the current price is given as $1100, the market value of the bond will be $1100.
Flotation Cost = 5% of $1100 = 0.05 * $1100 = $55
Step 2: Calculate the net proceeds.
Net Proceeds = Market Value - Flotation Cost
Net Proceeds = $1100 - $55 = $1045
Step 3: Determine the after-tax cost of the coupon rate.
After-tax Cost of Coupon Rate = Coupon Rate * (1 - Tax Rate)
The company's average tax rate is 28%, so the after-tax cost of the coupon rate can be calculated as follows:
After-tax Cost of Coupon Rate = 8% * (1 - 0.28) = 8% * 0.72 = 0.064 or 6.4%
Step 4: Determine the after-tax cost of debt.
After-tax Cost of Debt = (Net Proceeds / Par Value) * After-tax Cost of Coupon Rate
Par Value = $1000
After-tax Cost of Debt = ($1045 / $1000) * 6.4% = 1.045 * 6.4% = 6.688% or 6.69%
Therefore, the after-tax cost of debt for this bond issue is approximately 6.69%.