Mountain Retreat and Resort is undergoing a major expansion.The expansion will be financed by issuing new 15-year,$1,000 par,9% annual coupon bonds.The market price of the bonds is $1,070 each.The firm's flotation expense on the new bonds will be $50 per bond.The firm's marginal tax rate is 35%.What is the relevant cost of the new bonds for capital budgeting purposes?

Question

Quizplus · Accepted Answer

The relevant cost of the new bonds for capital budgeting purposes is the after-tax cost of debt.

Step 1: Calculate the net proceeds per bond after flotation expenses:

Net proceeds = $1,070 - $50 = $1,020

Step 2: Calculate the after-tax cost of debt:

Coupon payment = $1,000 x 9% = $90

Flotation expense = $50

Total annual cash outflow = $90 + $50 = $140

Net proceeds = $1,020

Yield to maturity = ?

Using the financial calculator, input:

N = 15

I/Y = ?

PV = -1,020

PMT = 90

FV = 1,000

Solve for I/Y = 6.209%

After-tax cost of debt = 6.209% x (1 - 0.35) = 4.04%

Therefore, the relevant cost of the new bonds for capital budgeting purposes is 4.04%, which is closest to option B (5.69%).

Mountain Retreat and Resort Is Undergoing a Major Expansion