Question

2. For every question, please write down each main step before you obtain the final answer. Correct final answer with incorrect related work (calculation) or without any work may receive 0 point. On the contrary, incorrect final answer with correct related work (calculation) will receive partial credits.

Question 1 –Debt Issue [6 points]: Eagle Sports Products (ESP) is considering issuing debt to raise funds to finance its growth during the next few years. The amount of the issue will be between $35 million and $40 million. ESP has already arranged for a local investment banker to handle the debt issue. The arrangement calls for ESP to pay flotation costs equal to 7 percent of the total market value of the issue.

Compute the flotation costs that ESP will have to pay if the market value of the debt issue is $36 million.

If the debt issue has a market value of $36 million, how much will ESP be able to use for its financing needs? That is, what will be the net proceeds from the issue for ESP? Assume that the only costs associated with the issue are those paid to the investment banker.

If the company needs $36 million to finance its future growth (i.e., the net proceeds from the issue is $36 million), how much debt must ESP issue?

Answer 1

Part 1)

The amount of flotation cost is arrived as below:

Amount of Flotation Cost = Market Value of Debt Issue*Flotation Cost

Using the information provided in the question in the above formula, we get,

Amount of Flotation Cost = 36,000,000*7% = $2,520,000

_____

Part 2)

The value of net proceeds from the issue is arrived as below:

Value of Net Proceeds = Market Value of Debt Issue - Amount of Flotation Cost = 36,000,000 - 2,520,000 = $33,480,000

_____

Part 3)

The value of debt issue to obtain $36,000,000 in net proceeds is arived as below

Value of Debt Issue = Total Funds Needed/(1-Flotation Cost) = 36,000,000/(1-7%) = $38,709,677.42 or $38,709,677

ESP must issue debt amounting to $38,709,677 if it wants to obtain $36,000,000 in net proceeds.