A firm wants to borrow $100 million for 5 years (pure discount, for simplicity).Which of the following sources has the lower effective interest cost?
$\begin{array}{l}
&&\text { Orig, Fee' }\
\text { Source } & \text { Interest Rate } & \text { Flotation Cost } \
\hline \text { Private Placement } & 9.00 \% & 1 \% \
\text { Public Issue } & 8.25 \% & 3 \%
\end{array}$

Question

A firm wants to borrow $100 million for 5 years (pure discount, for simplicity).Which of the following sources has the lower effective interest cost? 
$\begin{array}{l}
&&\text { Orig, Fee' }\
\text { Source } & \text { Interest Rate } & \text { Flotation Cost } \
\hline \text { Private Placement } & 9.00 \% & 1 \% \
\text { Public Issue } & 8.25 \% & 3 \%
\end{array}$

Quizplus · Accepted Answer

The effective interest cost is the annual interest rate that would have the same present value as the actual interest payments and flotation costs. For the private placement, the effective interest cost is:$$9.00\% + 1.00\% / 5 = 9.20\%$$For the public issue, the effective interest cost is:$$8.25\% + 3.00\% / 5 = 8.85\%$$Therefore, the public issue has the lower effective interest cost.

A Firm Wants to Borrow $100 Million for 5 Years