Gigawage Corp. is considering issuing a new 30-year debt isse that would pay an

Question

Gigawage Corp. is considering issuing a new 30-year debt isse that would pay an annual coupon of $85. 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. Gigawage Corp's CFO has pointed out that the firm would incure a flotation cost of 3% when initially issuing the bond issue. Remember that the flotation costs will be _________ (added or subtracted) from the amount the firm will receive from issuing its new bonds. The firm's marginal federal-plus-state tax rate is 40%.

To see the effect of flotation costs on the after-tax-cost of debt, calculate the after-tax cost of the firm's debt issue with and without flotation costs.

After-tax cost of debt without flotation cost

A. 4.8450%

B. 4.3350%

C. 5.3550%

D. 5.1000%

After-tax cost of debt with flotation cost

A. 5.5355%

B. 5.7991%

C. 5.2791%

D. 6.0627%

This is the cost of ___________(new, embedded) debt, and is different from the average cost of capital raised in the past.

Explanation / Answer

Interest Rate on Debt = 85/1000*100 = 8.5%

After tax cost of debt excluding flotation cost = 8.5(1-Tax Rate) = 8.5(1-0.40) = 5.1000%

Flotation cost will be subtracted from the amount the firm will receive from issuing its new bonds.

Flotation cost = 1000*3% = $30

Interest Rate on debt after Flotation cost = 85/[1000-30] = 8.7628%

After tax cost of debt with flotation cost = 8.7628[1-0.4] = 5.2577%

This the cost of new debt and is different from the average cost of capital raised in the past.

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