3. The cost of debt
What do lenders require, and what kind of debt costs thecompany?
The cost of debt that is relevant when companies are evaluatingnew investment projects is the marginal cost of the new debt to beraised to finance the new project.
Consider the case of Peaceful Book Binding Company (PBBC):
Peaceful Book Binding Company is considering issuing a new30-year debt issue that would pay an annual coupon payment of $100.Each bond in the issue would carry a $1,000 par value and would beexpected to be sold for a price equal to its par value.
PBBC’s CFO has pointed out that the firm would incur a flotationcost of 1% when initially issuing the bond issue. Remember, theflotation costs will be _________the proceeds the firm will receiveafter issuing its new bonds. The firm’s marginal federal-plus-statetax rate is 35%.
To see the effect of flotation costs on PBBC’s after-tax cost ofdebt (generic), calculate the after-tax cost of the firm’s debtissue with and without its flotation costs, and select the correctafter-tax costs (in percentage form):
| After-tax cost of debt without flotation cost: | __________ |
| After-tax cost of debt with flotation cost: | __________ |
This is the cost of _______ debt, and it is different from theaverage cost of capital raised in the past.
