8. ABC Corp. is undergoing a major expansion. The expansion will be financed by

Question

8. ABC Corp. is undergoing a major expansion. The expansion will be financed by issuing new 15-year, $1,000 par, 9% annual coupon bonds. The market price of the bonds is $1,070 each. Flotation expense on the new bonds will be $50 per bond. The marginal tax rate is 35%. What is the pre-tax cost of debt for the newly-issued bonds? 9. New Jet Airlines plans to issue 14-year bonds with a par value of 1,000 that will pay S60 every six months. The bonds have a market price of S1,220. Flotation costs on new debt will be 4%. If the firm has a 35% marginal tax bracket, what is cost of existing debt? 10. GHJ Inc. is investing in a new project of $16 million. It will raise $2 million of bonds, $4 million of preferred stock, and S10 million of new common stock. If the after-tax cost of debt is 7%, cost of preferred stock is 9%, the cost of retained earnings is 14%, and the cost of new commmon stock is 17%, what is the WACC?

Explanation / Answer

1. The calculation is done in the way that interest of 90$ is provided and at maturity the redemption amount I.e. FV will be 1000 and PV value today is 1070 , so when you calculate it in excel, you are calculating YTM. Which comes to 8.17%

Formulae for YTM= {C+ (F-P)/n}/ (F+P)/2= {90+(1070-1000)/15}/(1000+1070)/2= 8.17%

Note: flotation cost is ignored.

2. YTm for this also is calculated on the same lines FV= 1000, PV= 1220 , n = 14 years and we need to calculate I/Y.

120+ {(1220-1000)/n}/ {(1220+1000)/2} = 9.15% whiCh is on an annualized basis.

Alternatively, if you want to do it on half yearly basis, n= 28

C= 60$ which will come to 4.59% and annualizing it gives 4.59*2= 9.18%

After tax cost of debt= 9.18(1-0.35)= 5.97%

3. WACC= WD*kd+ we*ke+ wp*kp

Weights as given, bonds of 2 million weight will be 2/16= .125

Weight of preferred stock= 4/16= 0.25

Weight of equity= 10/16= 0.625

Weights* cost of components which comes to 13.75%

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