)B5. (Cost of borrowing alternatives) Exxon Mobil has a 34% taxrate and has deci
ID: 2662230 • Letter: #
Question
)B5. (Cost of borrowing alternatives) Exxon Mobil has a 34% taxrate and has decided to issue$100 million of seven-year debt. It has three alternatives. A U.S.public offering would
require an 8% coupon with interest payable semiannually and$900,000 of flotation
expense. A U.S. private placement would require an 8-3/8% couponwith interest payable
semiannually and $500,000 of flotation expense. A Eurobond offeringwould require an
8-1/8% coupon with interest payable annually and $1,100,000 offlotation expense.
a. Calculate the after-tax cost of borrowing for eachalternative.
b. Which alternative has the lowest cost of borrowing?
Explanation / Answer
Ans A. Option 1: Kd=I=8% Semiannual, Tax rate T= 0.34% As Bonds are issued at Par, Kd = Bond Coupon Rate To convert Semiannual rate of Kd to annual rate, we use EARformula Effective Annual Rate EAR = Kd = (1+Kd/2)^2 - 1 =(1+8%/2)^2 - 1 = 1.0816-1=0.0816 = 8.16% COst of Debt post Tax = Kd(1-T) = 8.16%(1-34%) = 5.386%Option 2: Kd=I=8 3/8% = 8.375% Semiannual, Tax rate T=0.34% As Bonds are issued at Par, Kd = Bond Coupon Rate To convert Semiannual rate of Kd to annual rate, we use EARformula Effective Annual Rate EAR = Kd = (1+Kd/2)^2 - 1 =(1+8.375%/2)^2 - 1 = 1.0855-1=0.0855 = 8.55% COst of Debt post Tax = Kd(1-T) = 8.55%(1-34%) = 5.643%
Option 3: Kd=I=8 1/8% Annual, Tax rate T= 0.34% As Bonds are issued at Par, Kd = Bond Coupon Rate As Interest rate is Annual basis , we just take Kd=8 1/8% =8.125% COst of Debt post Tax = Kd(1-T) = 8.125%(1-34%) = 5.363%
Ans B So Option 3 s cheapest as Kd is Lowest
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