CFA Practice Question

CFA Practice Question

Ameriscam, Inc. is considering the issuance of some junior subordinated debt. The Company's combined state/federal corporate tax rate is 30%, and the coupon on its outstanding senior debt is 7.55%. The proposed debt would pay an annual coupon. Very recently, Ameriscam has met with a corporate finance firm, who advised the Company that the pre-tax cost of a debt issuance would be 7.70%; Ameriscam's finance division mirrored these findings. A month earlier, a study in a popular financial magazine found that shareholder's require a 7.95% rate of return on similar investments.

Which of the following represents the best answer for Ameriscam's estimated after-tax cost of debt for this proposed debt issuance?
A. 5.39%
B. 5.285%
C. 5.565%
Explanation: Remember that in calculating the after-tax cost of debt for new debt issues, the MARGINAL cost of issuing new debt is the most relevant measure. In this example, the marginal cost of debt is given as 7.70%, and the after-tax cost of debt capital is found by multiplying (1 - corporate tax rate) by this figure. Specifically, the calculation of the after-tax cost of debt for Ameriscam is as follows: {pre-tax cost of issuing new debt 7.70% * [1-combined state/federal tax rate 30%]} = 5.39%. While the coupon rate on the firm's outstanding senior debt is often used as a proxy, this number is significantly inferior to the use of marginal figures. What is relevant in this example is the cost of new debt, and this can best be approximated by using the marginal cost of a new debt issue. Often, in capital budgeting and related corporate finance decisions, the only available figures are related to the cost and yield of outstanding debt, and in these instances, using the cost of outstanding debt is very appropriate. However, in this example, using the cost of existing debt does not yield the best possible answer.

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