Suppose your company needs to raise $28 million and you want to issue 15-year bonds for this purpose. Assume the required return on your bond issue will be 8 percent, and you're evaluating two issue alternatives: an 8 percent annual coupon and a zero coupon bond. Your company's tax rate is 35 percent. In 15 years, what will your company's repayment be if you issue the coupon bonds? What if you issue the zeroes? (Assume annual compounding on the zero coupon bond).

Question

Quizplus · Accepted Answer

For the coupon bonds:

Coupon rate = 8%
Face value = $28 million
Annual coupon payment = Coupon rate * Face value = 0.08 * $28 million = $2.24 million
Number of coupon payments = 15
Required return = 8%
Tax rate = 35%

PV of each coupon payment = Coupon payment / (1 + required return)^t + (tax rate * coupon payment / (1 + required return)^t)
where t = the year of the coupon payment

Using the above formula, we get the PV of all the coupon payments to be $21.10 million.

Also, at the end of 15 years, the company will have to repay the face value of the bond, which is $28 million.

Total repayment = PV of coupon payments + Face value = $21.10 million + $28 million = $49.10 million

For the zero coupon bonds:

Face value = $28 million
Required return = 8%
Number of years to maturity = 15
Tax rate = 35%

Using the formula for the present value of a single sum, PV = FV / (1 + required return)^t, we get the present value of the face value to be $11.86 million.

Total repayment = PV of face value + amount borrowed = $11.86 million + $28 million = $39.86 million

Therefore, the better choice is to issue the coupon bonds, as the total repayment amount is lower.

Suppose Your Company Needs to Raise $28 Million and You