Company Cosmo Cougs Inc. plans to issue 10-year bonds with a face value of $1,000 and an annual coupon rate of 8%. The market price of similar bonds is $1,054. Flotation costs are estimated to be 5.25% for each bond. If interest payments are made annually, and the company’s marginal tax rate is 34%, what is the after-tax cost of debt?

Question

BlackTom AI · Accepted Answer

We start by identifying the key data: the bond has a face value of $1,000, annual coupon rate of 8%, annual interest payments, market price of similar bonds $1,054, flotation costs 5.25%, and a marginal tax rate of 34%. We must compute the after-tax cost of debt using net proceeds from issuing the debt.

Option by option analysis:

Option A: 5.29%
This matches the standard formula for after-tax cost of debt when flotation costs are present: after-tax cost = (annual coupon × (1 − tax rate)) / net proceeds. Here, annual coupon = 0.08 × 1000 = 80. Tax shield reduces payments to 80 × (1 − 0.34) = 80 × 0.66 = 52.8. Net proceeds = market price × (1 − flotation cost) = 1054 × (1 − 0.0525) = 1054 × 0.9475 ≈ 998.665. Therefore, after-tax cost = 52.8 / 998.665 ≈ 0.0529 = 5.29%. This aligns perfectly with the calculation.

Option B: 8.02%
If one overlooked flotation costs and tax effects, one might incorrectly use the pre-tax coupon rate (8%) or miscalculate net proceeds. Using 8% directly would ignore the tax shield and flotation impact, leading to a higher, incorrect figure. Since the after-tax benefit reduces the effective cost, 8.02% is not consistent with the given data.

Option C: 4.01%
This would result from an incorrect method, such as dividing the after-tax coupon by a larger denominator or misapplying tax. For instance, if net proceeds were assumed near the full price without subtracting flotation costs, or if the tax impact were partly ignored, a value around 4% could accidentally appear, but it does not reflect the stated flotation costs and tax impact.

Option D: 7.22%
A misstep here would be to underweight the tax shield or to neglect the reduction in proceeds from flotation costs, producing a higher rate than the true after-tax cost. 7.22% is inconsistent with the correct net proceeds and after-tax coupon relationship described by the formula.

In summary, the correct approach weighs the after-tax coupon against the actual funds raised after flotation costs, yielding 5.29%. The alternative options arise from misapplying tax effects, flotation costs, or using the pre-tax coupon rate without adjustments.

MSB-250-300-002 Proctored Midcourse Exam 2

View Explanation

Log in for full answers

Similar Questions

A company has outstanding long-term debt with a yield to maturity of 7.5% and a marginal income tax rate of 30%. Given this information, what is the after-tax cost of debt for this company?

Rockingham Motors issued a 20-year, 8 percent semiannual bond 3 years ago. The bond currently sells for 98.6 percent of its face value. The company's tax rate is 35 percent. What is the aftertax cost of debt?

A company is issuing bonds that have a $1,000 face value and that pay an annual coupon of $62. The flotation cost associated with these bonds is 12.3% and they have a market value of $1,135.22. The bonds mature in 15 years. The firm’s marginal tax rate is 35%. What is the after-tax cost of debt?

A firm's aftertax cost of debt will increase if there is a(n):

TB MC Qu. 60 USA Manufacturing issued... USA Manufacturing issued 30-year, 7.2 percent semiannual bonds 6 years ago. The bonds currently sell at 101 percent of face value. What is the firm's aftertax cost of debt if the tax rate is 21 percent?

Which of the following statements regarding the aftertax cost of debt is accurate?

Galvatron Metals has a bond outstanding with a coupon rate of 6.1 percent and semiannual payments. The bond currently sells for $1,933 and matures in 19 years. The par value is $2,000 and the company's tax rate is 22 percent. What is the company's aftertax cost of debt?

Venus Limited has market value of debt of $80 million, market value of equity of $140 million, and cash of $20 million. The pre-tax cost of debt is 10%, the cost of equity is 14%, and the tax rate is 30%. The after-tax cost of debt is …………

More Practical Tools for Students Powered by AI Study Helper

Homework AI Solver

Stylized AI Paper Writer

Plagiarism Checker Assistant

Citation AI Academic Writing Tool

In-Class Translation Assistant

AI Note Generator

AI Quiz Answers

Past Exam Questions from University Test Bank

Smart Practice Assistant

Adaptive Practice

Making Your Study Simpler