Aa Aa What do lenders require, and what kind of debt costs the company? The cost

ID: 2619500 • Letter: A

Question

Aa Aa What do lenders require, and what kind of debt costs the company? The cost of debt that is relevant when companies are evaluating new investment projects is the merginal cost of the new debt to be raised to finance the new project. Consider the case of Peaceful Book Binding Company: Peaceful Book Binding Company is considering issuing a new 15-year debt issue that would pay an annual coupon payment of $75. Each bond in the issue would carry a $1,000 par value and would be expected to be sold for a price equal to its par value. PBBC's CFO has pointed out that the firm would incur a flotation cost of 296 when initially issuing the bond issue. Remember, the flotation costs will be bonds. The firm's marginal federal-plus-state tax rate is 40%. from the proceeds the firm will receive after issuing its new To see the effect of flotation costs on PBBC's after-tax cost of debt (generic), calculate the after-tax cost of the firm's debt issue with and without its flotation costs, and select the correct after-tax costs from the following boxes. After-tax cost of debt without flotation cost: After-tax cost of debt with flotation cost This is the cost of debt, and it is different from the average cost of capital raised in the past.

Explanation / Answer

FILL IN BLANK

PAID

AFTER TAX COST OF DEBT WITHOUT FLOTATION COST

(INTEREST/ISSUE PRICE)*(1- TAX RATE)

(75/1000)*(1-.4)

4.50%

AFTER TAX COST OF DEBT WITH FLOTATION COST

(INTEREST/NET PROCEEDS)*(1- TAX RATE)

(75/980)*(1-.4)

4.59%

Additional debt