2. Drywall Systems, Inc., is presently in discussions with its investment banker

Question

2. Drywall Systems, Inc., is presently in discussions with its investment bankers regarding the issuance of new bonds. The investment banker has informed the company that different maturities will carry different coupon rates and sell at different prices. Drywall Systems 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. This implies that the firm will net $970 per bond, before the adjustment for the premium (+) or discount (-). The company is taxed at a rate of 40%. Calculate the after-tax costs of financing with each of the following alternatives. Show work

Alternative       Coupon Rate        Time to Maturity       Premium (+) or Discount (-)
A                      9%                        16 years                     + $250
B                      7%                         5 years                     + $50
C                      6%                         7 years                      Par
D                     5%                        10 years                      - $75

Explanation / Answer

Calculating the after-tax cost of debt using excel sheet: For Bond-A: Face value = $1000 Current price = $970 + $250                     = $1,220 Coupon payment = $1,000 * 9%                           = $90 Time to maturity = 16yrs Step1: Go to excel and click "Insert" to insert the function. Step2: Select the "Rate" function as we are finding the yield to maturity in this case. Step3: Enter the cash flows as Nper = 16; PMT = -90; PV = 1220; FV = -1000 Step4: Click "OK" to get the desired value. The value comes to "6.71%" After-tax cost of debt = Before-tax cost of debt (1 - Tax rate)                                 = 0.0671 (1-0.40)                                 = 0.04026 or 4.026% Therefore, the after-tax cost of debt for Bond-A is 4.026% For Bond-B: Face value = $1000 Current price = $970 + $50                     = $1,020 Coupon payment = $1,000 * 7%                           = $70 Time to maturity = 5yrs Step1: Go to excel and click "Insert" to insert the function. Step2: Select the "Rate" function as we are finding the yield to maturity in this case. Step3: Enter the cash flows as Nper = 5; PMT = -70; PV = 1020; FV = -1000 Step4: Click "OK" to get the desired value. The value comes to "6.52%" After-tax cost of debt = Before-tax cost of debt (1 - Tax rate)                                 = 0.0652 (1-0.40)                                 = 0.039 or 3.9% Therefore, the after-tax cost of debt for Bond-B is 3.9% For Bond-C: Face value = $1000 Current price = $970   Coupon payment = $1,000 * 6%                           = $60 Time to maturity = 7yrs Step1: Go to excel and click "Insert" to insert the function. Step2: Select the "Rate" function as we are finding the yield to maturity in this case. Step3: Enter the cash flows as Nper = 7; PMT = -60; PV = 970; FV = -1000 Step4: Click "OK" to get the desired value. The value comes to "6.55%" After-tax cost of debt = Before-tax cost of debt (1 - Tax rate)                                 = 0.0655 (1-0.40)                                 = 0.0393 or 3.93% Therefore, the after-tax cost of debt for Bond-C is 3.93% For Bond-D: Face value = $1000 Current price = $970 - $75                     = $895 Coupon payment = $1,000 * 5%                           = $50 Time to maturity = 10yrs Step1: Go to excel and click "Insert" to insert the function. Step2: Select the "Rate" function as we are finding the yield to maturity in this case. Step3: Enter the cash flows as Nper = 10; PMT = -50; PV = 895; FV = -1000 Step4: Click "OK" to get the desired value. The value comes to "6.46%" After-tax cost of debt = Before-tax cost of debt (1 - Tax rate)                                 = 0.0646 (1-0.40)                                 = 0.0387 or 3.87% Therefore, the after-tax cost of debt for Bond-D is 3.87% Face value = $1000 Current price = $970 + $50                     = $1,020 Coupon payment = $1,000 * 7%                           = $70 Time to maturity = 5yrs Step1: Go to excel and click "Insert" to insert the function. Step2: Select the "Rate" function as we are finding the yield to maturity in this case. Step3: Enter the cash flows as Nper = 5; PMT = -70; PV = 1020; FV = -1000 Step4: Click "OK" to get the desired value. The value comes to "6.52%" After-tax cost of debt = Before-tax cost of debt (1 - Tax rate)                                 = 0.0652 (1-0.40)                                 = 0.039 or 3.9% Therefore, the after-tax cost of debt for Bond-B is 3.9% For Bond-C: Face value = $1000 Current price = $970   Coupon payment = $1,000 * 6%                           = $60 Time to maturity = 7yrs Step1: Go to excel and click "Insert" to insert the function. Step2: Select the "Rate" function as we are finding the yield to maturity in this case. Step3: Enter the cash flows as Nper = 7; PMT = -60; PV = 970; FV = -1000 Step4: Click "OK" to get the desired value. The value comes to "6.55%" After-tax cost of debt = Before-tax cost of debt (1 - Tax rate)                                 = 0.0655 (1-0.40)                                 = 0.0393 or 3.93% Therefore, the after-tax cost of debt for Bond-C is 3.93% For Bond-D: Face value = $1000 Current price = $970 - $75                     = $895 Coupon payment = $1,000 * 5%                           = $50 Time to maturity = 10yrs Step1: Go to excel and click "Insert" to insert the function. Step2: Select the "Rate" function as we are finding the yield to maturity in this case. Step3: Enter the cash flows as Nper = 10; PMT = -50; PV = 895; FV = -1000 Step4: Click "OK" to get the desired value. The value comes to "6.46%" After-tax cost of debt = Before-tax cost of debt (1 - Tax rate)                                 = 0.0646 (1-0.40)                                 = 0.0387 or 3.87% Therefore, the after-tax cost of debt for Bond-D is 3.87% Face value = $1000 Current price = $970   Coupon payment = $1,000 * 6%                           = $60 Time to maturity = 7yrs Step1: Go to excel and click "Insert" to insert the function. Step2: Select the "Rate" function as we are finding the yield to maturity in this case. Step3: Enter the cash flows as Nper = 7; PMT = -60; PV = 970; FV = -1000 Step4: Click "OK" to get the desired value. The value comes to "6.55%" After-tax cost of debt = Before-tax cost of debt (1 - Tax rate)                                 = 0.0655 (1-0.40)                                 = 0.0393 or 3.93% Therefore, the after-tax cost of debt for Bond-C is 3.93% For Bond-D: Face value = $1000 Current price = $970 - $75                     = $895 Coupon payment = $1,000 * 5%                           = $50 Time to maturity = 10yrs Step1: Go to excel and click "Insert" to insert the function. Step2: Select the "Rate" function as we are finding the yield to maturity in this case. Step3: Enter the cash flows as Nper = 10; PMT = -50; PV = 895; FV = -1000 Step4: Click "OK" to get the desired value. The value comes to "6.46%" After-tax cost of debt = Before-tax cost of debt (1 - Tax rate)                                 = 0.0646 (1-0.40)                                 = 0.0387 or 3.87% Therefore, the after-tax cost of debt for Bond-D is 3.87% Face value = $1000 Current price = $970 - $75                     = $895 Coupon payment = $1,000 * 5%                           = $50 Time to maturity = 10yrs Step1: Go to excel and click "Insert" to insert the function. Step2: Select the "Rate" function as we are finding the yield to maturity in this case. Step3: Enter the cash flows as Nper = 10; PMT = -50; PV = 895; FV = -1000 Step4: Click "OK" to get the desired value. The value comes to "6.46%" After-tax cost of debt = Before-tax cost of debt (1 - Tax rate)                                 = 0.0646 (1-0.40)                                 = 0.0387 or 3.87% Therefore, the after-tax cost of debt for Bond-D is 3.87%

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