CMA Study Group

CMA part 2 cost of capital

  • 1.  CMA part 2 cost of capital

    Posted 6 days ago

    where did he get the 1.01 to calculate the market price?

    Fact Pattern:  DQZ Telecom is considering a project for the coming year that will cost $50 million. DQZ plans to use the following combination of debt and equity to finance the investment.
    1. Issue $15 million of 20-year bonds at a price of $101, with a coupon rate of 8%, and flotation costs of 2% of par.
    2. Use $35 million of funds generated from earnings.
    3. The equity market is expected to earn 12%. U.S. Treasury bonds are currently yielding 5%. The beta coefficient for DQZ is estimated as .60. DQZ is subject to an effective corporate income tax rate of 40%.
     Question: 10The before-tax cost of DQZ's planned debt financing, net of flotation costs, in the first year is
    Answer (B) is correct.
    The cost of new debt equals the annual interest divided by the net issue proceeds. The annual interest is $1.2 million ($15,000,000 × .08 coupon rate). The proceeds amount to $14,850,000 [($15,000,000 × 1.01) market price – ($15,000,000 × .02) flotation costs]. Thus, the company is paying $1.2 million annually for the use of $14,850,000, a cost of 8.08% ($1,200,000 ÷ $14,850,000).


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    Tayba Al-Mehdar
    Analyst
    Khobar
    Saudi Arabia
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  • 2.  RE: CMA part 2 cost of capital

    Posted 6 days ago
    Hi Tabya,

    Bond is being traded at premium ie 101
    101/100 =1.01

    OR
    101- 2 /100         = 0.99
    0.99*15000000  =14,850,000




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    Sanjana
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