Chapter 9, Problem 9.2P

a)

Summary Introduction

To discuss:

The net proceeds from the sale of a bond.

Introduction:

The net proceeds from the sale of a bond are defined as the funds that a firm receives from the sale of a bond. Bonds are either sold at discount, at par or at premium. The net proceeds from the sale of a bond is the difference between the total proceeds and the underwriting charges and brokerage fees. Floatation cost refers to the total cost of issuing and selling of securities.  Floatation cost includes two components the underwriting charges and brokerage fees.  The floatation costs reduce the total proceeds received by the firm as they are paid from the bond funds. The floatation cost is the difference between the total proceeds and net proceeds.

b)

Summary Introduction

To discuss:

The cash flows from the point of view over the maturity of bonds.

Introduction:

Every firm requires capital to fund their long term investments. The typical sources of capital for a firm include debt and equity. Firms often raise their capital by selling securities such as common stock, preferred stock, and bonds to investors and also by reinvesting profits back to the firm.  The capital structure of a firm is the mixture of debt and equity financing employed by the firm.

c)

Summary Introduction

To discuss:

The before-tax and after –tax cost of debt.

Introduction:

The before tax cost of debt is defined as the rate of return the firm must pay on new borrowing. If a firm has zero floatation costs, then the firm’s before-tax cost of debt would be equal to required rate of return by the bondholders. The interest payments made to the bondholders are tax deductible for the firm. The interest expenses on firm reduce the taxable income and the tax liability of the firm. The before -tax cost debt is the rate of return the firm must pay on a new borrowing. The after-tax cost of a debt is the cost after deducting the tax amount.

When after tax cost of the debt is r_i and r_d is the before-tax cost of a debt, with the tax rate of the firm T, before-tax cost can be converted to after -tax cost by using the following equation,

${\text{r}}_{\text{i}}={\text{r}}_{\text{d}}\times \left(\text{1}-\text{T}\right)$

d)

Summary Introduction

To discuss:

To calculate the before-tax and after –tax cost of debt using approximation formula.

Introduction:

The before -tax cost debt is the rate of return the firm must pay on a new borrowing. The after-tax cost of a debt is the cost after deducting the tax amount.

When after tax cost of the debt is r_i and r_d is the before-tax cost of a debt, with the tax rate of the firm T, before-tax cost can be converted to after -tax cost by using the following equation,

${\text{r}}_{\text{i}}={\text{r}}_{\text{d}}\times \left(\text{1}-\text{T}\right)$

Using the approximation the before-tax cost of the debt is calculated when the annual interest payment in dollars (I), the net proceeds from the sale of a bond (N_d) and term of the bond in years (n) , using the equation,

${\text{r}}_{\text{d}}\text{=}\frac{\left(\text{I}+\left(\frac{\text{[(\$1,000}-{\text{N}}_{\text{d}}\text{)]}}{\text{n}}\right)\right)}{\left(\frac{{\text{(N}}_{\text{d}}+\text{\$1,000)}}{\text{2}}\right)}$

e.

Summary Introduction

To discuss:

Comparison between the two approaches.

Introduction:

The before -tax cost debt is the rate of return the firm must pay on a new borrowing. The after-tax cost of a debt is the cost after deducting the tax amount.

When after tax cost of the debt is r_i and r_d is the before-tax cost of a debt, with the tax rate of the firm T, before-tax cost can be converted to after -tax cost by using the following equation,

${\text{r}}_{\text{i}}={\text{r}}_{\text{d}}\times \left(\text{1}-\text{T}\right)$