Currently, Warren industries can sell 15-year, $1,000 par value bonds paying ann

Question

Currently, Warren industries 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 cost of $30 per bond will be incurred in this process. The firm is in the 40% tax bracket.

b. Show the cash flows from the firm’s point of view over the maturity of the bond.

c. Calculate the before-tax and after tax costs of debt.

d. Use the approximation formula to estimate the before tax and after tax costs of debt

e. Compare and contrast the costs of debt calculated in parts c and d. Which approach do you prefer? Why?

Explanation / Answer

a) Net proceeds from sale of Bond

      1010-30=980

b)At period 0= 1010-30=980

between Period 1 to 15 = outflow of 1000*0.12= - 120

At the end of 15 years =1000

ie. Period         0       1-15         15

    CF             980     -120      -1000

c) Before tax cost of Debt

=RATE(15,120,-980,1000)= 12.30%

After Tax cost of Debt =12.3 *(1-0.4)=7.379%=7.38%

d) approximate method= 120 + (1000-980)/15    = 12.26%

   (980+1000)/2

after tax cost of debt =12.26 *(1-0.4)=7.36%

e) The calculation method is more accurate than approximate method, however the results of approximate are fairly accurate but the calculation method is better.             

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