With the Text tool, highlight only the first letter of the paragraph. From the Character Palette, resize the letter appropriately and then set a negative baseline for the letter. In the Paragraph Palette, indent the paragraph as needed and set a negative first line.
Larry beat me with an alternative method. His works well if your drop cap is "unadorned." If you want to prettify it in any way, try the text wrap method.
Th first letter with a negative baseline value is now overlapping the second line of text below. How do I get the second line underneath to move over to the right so that it is not covered up by the paragraph's first letter now?
Just set a tab at the correct point in the second line and tab the start of the second line over
Alternatively:
(The drop cap and the two lines need to be a separate paragraph than the third (and fourth and fifth...) lines for this method and the text must be in a box.)
Set a left margin about the width of the drop cap, than set the first line indent to be the negative value of the left margin value. Tune as required. Note that you have to set the margin first, if you try and set the negative first line indent first, Illustrator will tell you youre crazy, it cant be done so piss off (the logic is that the first line indent cannot be wider than the margin).
Another method is to type your cap, (then create outlines) This is important so that you can eliminate any leading. Next draw a transparent box around the letter to assign the amount of wrap. Group the box and the cap and bring the object on top of your body text. Then select Object > Text Wrap > Make. I have found this to be a fast way to make drop caps and it allows for very precise control. One side effect is that it does not spell check.
In any case I find the two text wrap methods to be a better way as it is easier to enlarge the Character and still have the text wrap automatically with out you needed to reset to baseline offset etc.
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