Question

The cost of debt that is relevant when companies are evaluating new investment projects is the marginal cost of the new debt to be raised to finance the new project. Consider the case of Purple Lemon Fruit Company (Purple Lemon): Purple Lemon Fruit 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. Purple Lemon’s CFO has pointed out that the firm would incur a flotation cost of 2% when initially issuing the bond issue. Remember, the flotation costs will be______________(added to/ subtracted) the proceeds the firm will receive after issuing its new bonds. The firm’s marginal federal-plus-state tax rate is 40%.

To see the effect of flotation costs on Purple Lemon’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 (in percentage form):

After-tax cost of debt without flotation cost:__________(3.8250%, 4.5%, 4.7250%, 4.0500%)

After-tax cost of debt with flotation cost: _____________(4.6379%, 4.7250%, 5.1750%, 4.2750%)

This is the cost of_________________ (historical/marginal) debt, and it is different from the average cost of capital raised in the past.

Answer 1

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BOND - Microsoft Excel (Product Activation Failed) Add-Ins View - 2x Σ AutoSum : A Dr General File Home Insert Page Layout Formulas Data Review % Cut Calibri -11AA = = = Ea Copy Paste B I U B- Format Painter A Clipboard Font DS394 for Wrap Text Merge & Center - $ -% . Formeltinget some Fill 2 Clear Formatting as Table Styles sort on Insert Delete Format 2 Clear sort & Find a Sort & Filter Editing Styles Find & Select Alignment Number Cells DO DP DQ DR DS DI DU DV BLANK SUBTRACTED WITHOUT FLOTATION COST LIFE ANNUAL COUPON FV 15 75 1000 1000 pv 390 391 392 393 394 395 396 397 398 399 400 401 402 403 404 405 406 407 408 ANSWER ANSWER BEFORE TAX COST OF DEBT COST OF DEBT (AFTER TAX) = 7.50%(1-0.4) = 7.50% [=RATE(DQ393,-DQ394,DQ396,-DQ395)] 4.5% 15 WITH FLOTATION COST LIFE ANNUAL COUPON FV PV 75 1000 980 [1000 - 2%(1000)] 409 ANSWER BLANK YIELD SPOT Sheet2 AFN ferences COST OF DEBT 7.7298% (=RATE(DQ402,-DQ403,DQ405,-DQ404)] COST OF DEBT (AFTER TAX) = 7.7298%(1-0.4) = 4.6379% MARGINAL RATE BANKING NOTE 51 53 CLEAN PRICE $10 BIDDING, UNDERWRITING EUAC AW LIFELP, IP, MRP, INFLATION WARRANT refund 54 55 56 0 BOU 120% EJENO 9 * 10 0 NEM Rea ENG 31-10-2019