Question

The required return (or cost) of previously issued debt is often referred to as the projected rate. It usually differs from the cost of newly raised financial capital. Consider the case of Peaceful Book Binding Company: Peaceful Book Binding Company is considering issuing a new twenty-five-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 market price equal to its par value. PBBC's CFO has pointed out that the firm will incur a flotation cost of 2% when initially issuing the bond issue. Remember, these flotation costs will be subtracted from the proceeds the firm will receive after issuing its new bonds. The firm's marginal federal-plus-state tax rate is 30%. To see the effect of flotation costs on PBBC's after-tax cost of debt, calculate the before-tax and after-tax costs of the firm's debt issue with and without its flotation costs, and insert the correct costs into the boxes. (Note: Round your answer to two decimal places.) Before-tax cost of debt without flotation cost: After-tax cost of debt without flotation cost: 5.25 % Before-tax cost of debt with flotation cost: After-tax cost of debt with flotation cost: 5.38 %

Answer 1

Before tax cost of debt = 5.25/70%

= 7.5%

Before-tax cost of debt with flotation cost = 5.38/70%

=7.69%