Question

Cost of debt using both methods (YTM and the approximation formula) Currently, Warren Industries can sell 15-year, $1,000-par-value bonds paying annual interest at a 9% coupon rate. Because current market rates for similar bonds are just under 9%, Warren can sell its bonds for $1,020 each; Warren will incur flotation costs of $20 per bond. The firm is in the 26% tax bracket. a. Find the net proceeds from the sale of the bond, Nd- b. Calculate the bond's yield to maturity (YTM) to estimate the before-tax and after-tax costs of debt. c. Use the approximation formula to estimate the before-tax and after-tax costs of debt.

Answer 1

a.

N_d = Selling Price - Flotation Cost

N_d = 1,020 - 20 = $1,000

b.

As Bond Price = Current Price after flotation cost,

Yield to Maturity = 9.00%

Before-tax cost of Debt = 9.00%

After-tax cost of Debt = (1 - 0.26)(0.09) = 6.66%

c.

Calculating YTM by Approximate Formula,

YTM = (90 + (1,000 - 1,000)/15)/(1,000 + 1,000)/2

YTM = 9%

Before-tax cost of Debt = 9.00%

After-tax cost of Debt = (1 - 0.26)(0.09) = 6.66%