P9-2: Cost of debt using both methods Currently, Warren Industries can sell 15-year, $1,000-par-value bonds paying annual interest at a 7% coupon rate. Because cur-rent market rates for similar bonds are just under 7%, Warren can sell its bonds for $1,010 each; Warren will incur flotation costs of $30 per bond in this process. The firm is in the 40% tax bracket. a. Find the net proceeds from sale of the bond, Nd. b. Show the cash flows from the firm’s point of view over the maturity of the bond. c. Calculate the before-tax and after-tax costs of debt. d. Use the approximation formula to estimate the before-tax and after-tax costs of debt. e. Compare and contrast the costs of debt calculated in parts c and d. Which approach do you prefer? Why?

Answer and Explanation:

The computation is shown below:

a. The Net proceeds from the sale of Bond are

= $1010 - $30

= $980

b. The streams of money should be reflected from the perception of an organization for over the security development

Year 0

Cash inflow

Years 1 to 14 Cash outflow

Year 15

Net cash outflow

$980

($120) each year

($1,120) ($120 coupon + $1000 maturity)

c. The before tax cost of debt is 7%

And, the after tax cost of debt si

= 7% × (1 - 0.40)

= 4.2%

d. The Before Tax Cost of Debt is

= ($120 ÷ $980) × 100

=  12.24%

And,

After tax Cost of Debt is

= 12.24% × (1 - 0.40)

= 7.35%

d. Both methods should be considered and also they are based on the available resources. If we considered the financial calculator than use the first one and also the first one is relevant as it shows the accurate results

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