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Calculatig face value and effective after-tax cost of debt

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Bristol Myers Squibb, an international pharmaceutical company, is initiating a new project for which it requires $2.5 million in debt capital. The current plan is to sell 20-year bonds that pay 4.2% per year, payable quarterly, at a 3% discount on the face value. BMS has an effective tax rate of 35% per year. Determine (a) the total face value of the bonds required to obtain $2.5 million and (b) the effective annual after-tax cost of debt capital.

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Solution Preview

Please refer attached file for better clarity of tables and formulas.

Solution:

(a) the total face value of the bonds required to obtain $2.5 million and
Face value of $2.5 million debt=2.5/(1-3%)=$2.57732 million

(b) the effective annual after-tax cost of debt capital.
Let us see cash flows associated with bond issue
Selling price=2.5000 million
Face value=2.577319588 million
Coupon amount=2.57732*4.2/4%=0.0271 million
Cash flow from issuer's point of view
Quarter # Cash flow
0 2.5000
1 -0.0271
2 -0.0271
3 -0.0271
4 -0.0271
5 -0.0271
6 -0.0271
7 ...

Solution Summary

Solution determines the total face value of bonds and effective after-tax cost of debt.

$2.19