The cost of debt Gronseth Drywall Systems, Inc., is in discussions with its inve

Question

The cost of debt Gronseth Drywall Systems, Inc., is in discussions with its investment
bankers regarding the issuance of new bonds. The investment banker has informed
the firm that different maturities will carry different coupon rates and sell at
different prices. The firm must choose among several alternatives. In each case, the
bonds will have a $1,000 par value and flotation costs will be $30 per bond. The
company is taxed at a rate of 40%. Calculate the after-tax cost of financing with
each of the following alternatives.
Alternative Coupon rate   Time tomaturity (years) Premium or discount
A 9% 16 $250
B 7 5 50
C 6 7 par
D 5 10 2 75

Explanation / Answer

Assumption ;- It is not cleared about whether the bond is issued at premium or at discount ,so we assume that $250 , $275 at premium over $1000 par value and $50 is at discount below par value

Alternative A :

Cost of debt after tax = interest + 1/maturity years ( realisable value - net proceed) * ( 1 - tax rate)

1/2 ( realisable value + net proceed)

= ($1000 * 9%) + 1/16 ( 1000 - 720) * 0.6

1/2 (1000 + 720)

= 90 + 17.5 / 860 * 0.6

= 7.5%

Note:   net proceed = $1000 - 30(Floating cost) +250(Premium)

   = $720

Alternative B :

Cost of debt = (1000 * 7%) + 1/5{ 1000 - (1000-30-50) } * 0.6

1/2 (1000 + 920)

= (70 + 16) / 960 * 0.6

= 5.4%

Alternative C :

Cost of debt = (1000 * 6% ) + 1/6( 1000 - {1000-30)} * 0.6

1/2 (1000 + 970)

= ( 60 + 5) / 985 * 0.6

= 3.96 %

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