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.
- 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.
- Use $35 million of funds generated from earnings.
- 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%.
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Question:
10The before-tax cost of DQZ's planned debt financing, net of flotation costs, in the first year is
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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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