10.00% is the sum of the coupon rate and the flotation rate.
This answer could result from using the investors' expected return on the equity market (.12) and reducing it by 2% (flotation costs) of the 12%, or .0024. The expected return on the equity market is not used to calculate the cost of debt.
Proceeds are $14,850,000 [(1.01 x $15,000,000) ? (.02 x $15,000,000)]. Interest paid during the first year will be $1.2 million (.08 coupon rate x $15,000,000). Thus, the company is paying $1.2 million for one year for the use of $14,850,000, a rate of 8.08% ($1,200,000 / $14,850,000). Note that this is not the effective interest rate for the life of the bond but only the cash cost for the first year . In order to calculate the true effective interest rate of new debt where there are flotation costs and a bond premium, it is necessary to incorporate the amortization of the premium as well as the amortization of the bond issue costs, because the face amount of the bond is what will be paid back at its maturity. (And in reality, amortization of bond issue costs is usually not even included in the calculation of the effective interest rate, because that is usually not material.) Since such an in-depth calculation would take too much time in a question like this on an exam where time is limited, this question asks only for the cost of the debt financing in the first year , not the effective annual interest rate.
7.92% ignores the 2% flotation costs.
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The before-tax cost of DQZ's planned debt financing, net of flotation costs, in the first year is