Question

The required return (or cost) of previously issued debt is often referred to as the projected raised financial capital. rate. It usually differs from the cost of newly

Consider the case of Peaceful Book Binding Company:
Peaceful Book Binding Company is considering issuing a new twenty-five-year debt issue that would pay an annual coupon payment of $75. Each bond in the issue would carry a $1,000 par value and would be expected to be sold for a market price equal to its par value.
PBBC's CFO has pointed out that the firm will incur a flotation cost of 2% when initially issuing the bond issue. Remember, these flotation costs will be ___________from the proceeds the firm will receive after issuing its new bonds. The firm's marginal federal-plus-state tax rate is 30%.
To see the effect of flotation costs on PBBC's after-tax cost of debt, calculate the before-tax and after-tax costs of the firm's debt issue with and without its flotation costs, and insert the correct costs into the boxes. (Note: Round your answer to two decimal places.)
Before-tax cost of debt without flotation cost:______________

Answer 1

The before-tax cost of debt without flotation costs for Peaceful Book Binding Company's bond issue is 7.5%. Bond prices adjust to reflect changes in market interest rates and investors use present discounted value to evaluate a bond's worth given alternative investment opportunities.

Step-by-step explanation:

The student's question pertains to the calculation of the before-tax cost of debt for a bond issue by Peaceful Book Binding Company, both with and without considering flotation costs. The flotation costs are deducted from the proceeds of the new bond issue. To calculate the before-tax cost of debt without flotation costs, one would divide the annual coupon payment by the par value of the bond. Since the bond pays an annual coupon of $75 and has a par value of $1,000, the before-tax cost of debt without flotation costs is calculated as ($75/$1,000) * 100 = 7.5%. The before-tax cost of debt with flotation costs accounts for the reduction in the proceeds due to the 2% flotation cost.

Let's now consider the bond's risk and its impact on pricing and yields. A bond's market price adjusts according to changes in prevailing interest rates. If market interest rates increase, the attractiveness of older bonds with lower coupon rates decreases, leading to a price drop. Therefore, an 8% bond's price will be discounted below its par value to match the yield of newly issued bonds offering higher interest rates.

Finally, the concept of present discounted value is critical in assessing the value of a bond. If an investor can earn a higher interest rate elsewhere, they will discount the payment streams from a bond to determine how much they would pay for it today, given the higher opportunity cost of not investing in the alternative.