Purple Lemon Shipbuilders is considering issuing a new twenty-five-year debt issue that would pay an annual coupon payment of $90. Each bond in the issue would carry a $1,000 par value and would be expected to be sold for a market price equal to its par value.
Purple Lemon’s CFO has pointed out that the firm would incur a flotation cost of 3% when initially issuing the bond issue. Remember, the flotation costs will be the proceeds the firm will receive after issuing its new bonds. The firm’s marginal federal-plus-state tax rate is 40%.
Required:
To see the effect of flotation costs on Purple Lemon's after-tax cost of debt, calculate the before-tax and after-tax costs of the firm's debt issue with and without its flotation costs.