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azncpa
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Joined: 07 Nov 2009
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Posts: 108

Posted: 19 Jun 2010 at 09:29 \| IP Logged

DQZ Telecom is considering a project for the coming year, which 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 percent, and flotation costs of 2 percent of par.

• Use $35 million of funds generated from earnings.

The equity market is expected to earn 12 percent. U.S. treasury bonds are currently yielding 5 percent. The beta coefficient for DQZ is estimated to be .60. DQZ is subject to an effective corporate income tax rate of 40 percent.

The before-tax cost of DQZ's planned debt financing, net of flotation costs, in the first year is:

Answer is 8.08%.

[1.2m + (15m - 14,850,000)/2] / [14,850,000 + 15m]/2 = 8.08

Can someone explain how to get the 14,850,000 which is the net proceeds from the formula? i must be doing something wrong because i'm coming up with a different number?

Averalis
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Joined: 07 May 2010
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Posted: 19 Jun 2010 at 11:39 \| IP Logged

The bonds were issued at a premium, so you receive $15m *
1.01 ($15.15m), but the flotation costs of 2% of par will
reduce your net proceeds by 15m * .02 (.30m). Therefore,
the net proceeds are $15.15m - .30m = $14.85m.

When I did the problem I just netted the 101 and the 2%
flotation costs to come up with net proceeds of 99% of par,
and multiplied 15 million by .99 to get my answer. I don't
know which way works better for you.

__________________
FAR 05/17/10 - 99!
BEC 07/06/10 - 94
AUD 08/30/10 - 98
REG 10/28/10 - 99!!

Averalis
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Joined: 07 May 2010
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Posts: 93

Posted: 19 Jun 2010 at 11:44 \| IP Logged

Also, for what it's worth, I don't even bother using the
total values when computing the cost of debt. I don't see
the point in using such big numbers when you can just
simplify it by computing it based on one 1000 par bond. I
don't think I've seen any problems that mention a
flotation cost or premium as anything other than a
percentage of par.

Then I just use the market values for the weighting. It
just seems like you're more likely to make an error when
you're using 15 million rather than 1000.

80/(.99 * 1000) = 8.08% seems much simpler to me.

__________________
FAR 05/17/10 - 99!
BEC 07/06/10 - 94
AUD 08/30/10 - 98
REG 10/28/10 - 99!!

azncpa
Regular
Regular

Joined: 07 Nov 2009
Online Status: Offline
Posts: 108

Posted: 19 Jun 2010 at 19:14 \| IP Logged

hey thanks for the info. your way of calculating it was easier than the formula. i've just been using the formula provided in becker. i didn't realize there was another way to calculate it.

CPADESTINED
Newbie
Newbie

Joined: 07 Nov 2009
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Posts: 29

Posted: 22 Jun 2010 at 23:10 \| IP Logged

yes, much easier! Thank you for sharing the info!

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