fm10 14 - However, flotation costs are typically small on...

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b. What is the market interest rate on Harry Davis’ debt and its component cost of debt? Answer: Harry Davis’ 12 percent bond with 15 years to maturity is currently selling for $1,153.72. Thus, its yield to maturity is 10 percent: 0 1 2 3 29 30 | | | | | | -1,153.72 60 60 60 60 60 1,000 Enter n = 30, PV = -1153.72, pmt = 60, and FV = 1000, and then press the i button to find r d /2 = i = 5.0%. Since this is a semiannual rate, multiply by 2 to find the annual rate, r d = 10%, the pre-tax cost of debt. Since interest is tax deductible, Uncle Sam, in effect, pays part of the cost, and Harry Davis’ relevant component cost of debt is the after-tax cost: r d (1 - T) = 10.0%(1 - 0.40) = 10.0%(0.60) = 6.0%. Optional Question Should flotation costs be included in the estimate? Answer: The actual component cost of new debt will be somewhat higher than 6 percent because the firm will incur flotation costs in selling the new issue.
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Unformatted text preview: However, flotation costs are typically small on public debt issues, and, more important, most debt is placed directly with banks, insurance companies, and the like, and in this case flotation costs are almost nonexistent. Optional Question Should you use the nominal cost of debt or the effective annual cost? Answer: Our 10 percent pre-tax estimate is the nominal cost of debt. Since the firm's debt has semiannual coupons, its effective annual rate is 10.25 percent: (1.05) 2- 1.0 = 1.1025 - 1.0 = 0.1025 = 10.25%. However, nominal rates are generally used. The reason is that the cost of capital is used in capital budgeting, and capital budgeting cash flows are generally assumed to occur at year-end. Therefore, using nominal rates makes the treatment of the capital budgeting discount rate and cash flows consistent. Mini Case: 10 - 14...
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This note was uploaded on 07/13/2011 for the course FIN 4414 taught by Professor Staff during the Spring '08 term at University of Florida.

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