Exam paper- Dec-08-Jupitor Co.

Section (c) of the subject question demand a minimum rate that must be earned by the new debt. Although I understood that approaching this question with a mathematical formula, you would get more accurate figures, I approached this question with pure logic inspired by real life experience and found that the cost of new debt is what the minimum of return it must generate giving the following working to substantiate it.

Current cash flow 400.00
Add back interest net of Tax 33.60
(800*5.6%)
Total 433.60

Found the terminal value using this cash flow , the new cost of equity and retention rate given.

ie., 433.60 X 1+ (.0921*.30) /.0921-(.0921*.30) = $6,908 Million.

The above establishes that with the new cost of equity and without debt interest the firm’s share price would not fall from the current level.

Further we have to ensure that the same will not fall even after the payment of interest on new debt capital.

Gross interest of existing finance: 33.60/.75 = 44.80

This means without any debt
the firm will generate cash flow 444.80

Less interest on new Debt (93.00)
(2400*3.875%)

Net cash flow under new debt 351.80

Deficit compared to current level 48.20

This means The new debt has to generate 93.00
minimum to retain current level of earnings

This equal to the amount of interest of 3.875%
New Debt

Do you think this will work and will get some credit?? Please advice me whether or not my understanding is correct,

Thanks