You have decided to make an offer of $400,000,000 to buy a nuclear-power plant.

Question

You have decided to make an offer of $400,000,000 to buy a nuclear-power plant. Your tax rate is 40%. You would like to finance the purchase by issuing 20-year bonds at a 10% interest rate, payable annually. (a) What is your after-tax “cost of money” (taking into account that the interest payments on the bonds are tax-deductible, but not the repayment of principal in year 20), if the bonds sell for face value? (b) Would this financing option be good enough to consider if your minimum acceptable rate of return was 13%? (c) Would this financing option be good enough to consider if your minimum acceptable rate of return was 4%? (d) From the perspective of an investor who buys the bonds, what is the before-tax yield on the bonds if they sell for face value? (e) What is the before-tax yield on the bonds if they sell for a 10% discount (i.e., for $360,000,000)? (f) What is the before-tax yield on the bonds if they sell for a 15% premium over and above face value (i.e., for $460,000,000)?

Explanation / Answer

a)

Bonds sold at par value

Hence Yield = 10%

After tax cost = 10%*(1-40%) = 6%

b)

Yes, because cost of money of 6% is lower than required return of 13%

c)

No, because cost of money of 4% is higher than required return of 4%

d)

investor yield = 10%

e)

Use RATE function

=RATE(20,10%*400000000,-360000000,400000000) = 11.28%

f)

Use RATE function

=RATE(20,10%*400000000,-460000000,400000000) = 8.42%

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