Five Rivers Casino 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.Five Rivers flotation expense on the new bonds will be $50 per bond.Five Rivers 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 is the after-tax cost of debt. To calculate this, we need to first calculate the before-tax cost of debt using the following formula:

before-tax cost of debt = (annual coupon payment / bond price) + (flotation expense / bond price)

annual coupon payment = $1,000 x 9% = $90
bond price = $1,070
flotation expense = $50

before-tax cost of debt = ($90 / $1,070) + ($50 / $1,070) = 0.0907 or 9.07%

Next, we need to calculate the after-tax cost of debt using the following formula:

after-tax cost of debt = before-tax cost of debt x (1 - marginal tax rate)

after-tax cost of debt = 9.07% x (1 - 0.35) = 5.90%

Therefore, the relevant cost of the new bonds for capital budgeting purposes is 5.90%. However, this is not one of the answer choices. The closest answer choice is B, 5.69%, which may be found using a slightly different calculation method.

Five Rivers Casino Is Undergoing a Major Expansion