Question

Q1. Cost of Debt using both methods of approximation and calculation with cash flows. Currently, Coast Gulf Club can sell 15-year, $1,000-par-value bonds paying annual interest at a 12% coupon rate. As a result of current interest rates, the bonds can be sold for $1,010 each; flotation costs of $30 per bond will be incurred in this process. The firm is in the 21% tax bracket.

Answer 1

2]

Cash inflow in year 0 = sale price - flotation cost = $1010 - $30 = $980

Cash inflow in years 1 to 14 = annual coupon payment = par value * coupon rate = $1000 * 12% = $120

Cash inflow in year 15 = annual coupon payment + par value = $120 + $1000 = $1120

3]

Before-tax cost of debt is the YTM of the bond.

YTM is calculated using RATE function in Excel :

nper = 15 (years remaining until maturity with 1 annual coupon payment each year)

pmt = 120 (annual coupon payment)

pv = -980 (Sale price - flotation cost. This is entered with a negative sign because it is a cash outflow to buy the bond today).

fv = 1000 (par value of bond receivable at maturity).

RATE is calculated to be 12.30%. This is the before-tax cost of debt (YTM)

fRATE (15,120,-980,1000) A1 C D A В E 12.30% 1

After-tax cost of debt = YTM * (1 - tax rate)

After-tax cost of debt = 12.30% * (1 - 21%) = 9.72%

4]

Approximate YTM = [C + (F - P) / n] / [(F + P) / 2]

where C = coupon payment

F = par value

P = net sale proceeds (after flotation cost)

n = years to maturity

Approximate YTM = [120 + (1000 - 980) / 15] / [(1000 + 980) / 2]

Approximate YTM = 12.26%

Before tax cost of debt = 12.26%

After-tax cost of debt = YTM * (1 - tax rate)

After-tax cost of debt = 12.26% * (1 - 21%) = 9.68%