Marble Industrial Corp. (MIC) is considering issuing bonds to raise capital for

Question

Marble Industrial Corp. (MIC) is considering issuing bonds to raise capital for new projects and deciding between a privately placed issue and a public bond offering. The bonds will have a coupon rate of 8% (paid semiannually. a $1000 par value, and 5 years until maturity. If the bonds are privately placed, there will be no flotation costs. Alternatively, a public issue will require paying an investment bank 4% of the issue amount for flotation. MIC has a corporate tax rate of 40%. What is the difference in the after-tax component cost of debt capital for computing weighted average cost of capital for a public issue versus a private placement? (subtraction, not percentage difference) a. 0.00% b. 0.93% c. 1.78% d. 4.00%

Explanation / Answer

Ans:

The after tax cost of debt is used in computing the Weighted Average Cost of capital (WACC).

It is the cost of debt net of the tax savings from the tax deductions of interest:

After tax cost of debt= Cd* (1-t)

Cd- Interest cost of debt

t- Tax rate

In the given problem

Coupon rate- 8%

Flotation cost for public issue- 4%

= 0.08* (1-0.40)

= 0.08* 0.60= 0.048 or 4.8%

This can be computed in two steps:

Step 1- Compute after tax coupon payment

Semiannual coupon payment- $40

Tax rate- 40%

After tax coupon payment- $24

Step 2- Compute after tax cost based on the net proceeds received after adjusting the flotation cost. This can be obtained by using the following formula in excel:

= Rate (n, I, Bnp, M)

n- Maturity period ( 5 years)

Coupon cost in Dollars ($24)

Bnp- Net proceeds after adjusting floatation cost ($960)

M- Par value ($1000)

Now using the above formula this works out to be 5.731%

So difference between the after tax cost of these components is:

= 5.731- 4.80= 0.931%

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