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?
Orig. Fee/
Source Interest Rate Flotation Cost
Private Placement 9.
00% 1%
Public Issue 8.25% 3%
a. The private placement
b. The public issue
c. The costs are the same
FORMULA: Effective interest cost=ieffective = , where P is the amount of loan proceeds that the firm needs, f is the loan origination fee or flotation cost as a fraction of P, and istated is the stated interest cost.
B
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