The cost of debt Gronseth Drywall Systems Inc. is in discussions with its investment bankers

QUESTION

The cost of debt Gronseth Drywall Systems, Inc., is in discussions with its investment bankers regarding the issuance of new bonds. The investment banker has informed the firm that different maturities will carry different coupon rates and sell at different prices. The firm must choose among several alternatives. In each case, the bonds will have a $1,000 par value and flotation costs will be $30 per bond. The company is taxed at a rate of 40%. Calculate the after-tax cost of financing with each of the following alternatives.CouponTime toPremium orAlternativeratematurity (years)discountA9%16$250B7550C67parD510-75
Alternative A Cost of Debt = Cashflows add (Face Value less Price)/number of years/(Face Value add Price)/2 Cost of Debt = $ 90 add ($ 1,000 less $ 1,220)/16/($ 1,000 add $ 1,220)/2 Cost of Debt = 6.87 % After tax cost of Debt = 6.87%(1-0.40) After tax cost of Debt = 4.12 % Cash flows $ 90 (9% of $ 1,000) Face Value $ 1,000 Price $ 1,220 ($ 1,000 add $ 250 less $ 30) number of years 16 Alternative B Cost of Debt = Cashflows add (Face Value less Price)/number of years/(Face Value add Price)/2 Cost of Debt = $ 70 add ($ 1,000 less $ 1,020)/5/($ 1,000 add $ 1,020)/2 Cost of Debt = 6.54 % After tax cost of Debt = 6.54%(1-0.40) After tax cost of Debt = 3.92 % Cash flows $ 70 (7% of $ 1,000) Face Value $ 1,000 Price $ 1,020 ($ 1,000 add $ 50 less $ 30) number of years 5 Alternative C Cost of Debt = Cashflows add (Face Value less Price)/number of years/(Face Value add Price)/2 Cost of Debt = $ 60 add ($ 1,000

less $ 970)/7/($ 1,000 add $ 970)/2 Cost of Debt = 6.53 % After tax cost of Debt = 6.53%(1-0.40) After tax cost of Debt = 3.92 % Cash flows $ 60 (6% of $ 1,000) Face Value $ 1,000 Price $ 970 ($ 1,000 less $ 30) number of years 7 Alternative D Cost of Debt = Cashflows add (Face Value less Price)/number of years/(Face Value add Price)/2 Cost of Debt = $ 50 add ($ 1,000 less $ 895)/10/($ 1,000 add $ 895)/2 Cost of Debt = 6.39 % After tax cost of Debt = 6.39%(1-0.40) After tax cost of Debt = 3.83 % Cash flows $ 50 (5% of $ 1,000) Face Value $ 1,000 Price $ 895 ($ 1,000 less 75 less $ 30) number of years 10

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