Cost of Capital
This section provides an overview of the cost of capital, flotation costs, debt cost, preferred stock cost, and common stock cost. It also gives examples that show why WACC is important.
Cost of Debt
Learning Objectives
- Understand the components of the cost of debt.
- Identify the tax implications of debt.
- Explain how debt plays into the weighted average cost of capital.
The
cost of long-term debt, rd, is the after-tax cost of raising long-term
funds through borrowing. The important cost is our marginal debt cost
which is the next dollar of debt. If we were to issue another dollar (an
additional dollar) of debt, how much would it cost us? The cost of new
issuance of debt will probably not be the same as other debt we have
issued in the past (our historical debt cost), as we will need to
satisfy the current market demand.
How to Calculate the Cost of Debt
There
are a few methods to calculate the cost of debt. We are looking for the
yield to maturity (YTM), since this is the most accurate gauge of
market demand. How do we figure out the yield to maturity? If we have
outstanding debt of an appropriate maturity, we can assume the YTM on
this debt to be our cost.
If our company, however, has no
publicly traded debt, we could look to the market to see what the yield
is for other publicly traded debt of similar companies. Or, if we are
completely using bank financing, we can simply ask the bank to provide
us with an estimated rate.
Equation 12.1 Pre-Tax Cost of Debt
Component Cost of Debt = rd
Since
interest payments made on debt (the coupon payments paid) are tax
deductible by the firm, the interest expense paid on debt reduces the
overall tax liability for the company, effectively lowering our cost. To
calculate the real cost of debt we take out the tax liability.
Equation 12.2 After-Tax Cost of Debt
After-Tax Component Cost of Debt = rd − (rd × T) = rd × (1 − T)
Here, rd is the before tax return and T is the corporate tax rate.
Worked Example: Falcons Footwear
Falcons
Footwear is a company that produces sneakers for children. Each sneaker
has a black and red falcon head on it. Their marginal tax rate is 40%,
and the have $100 million notional, 30 year bonds with a 7% coupon. The
bonds currently sell for par. What's the after tax cost of debt?
Since the bonds are selling for par, we know that the YTM equals the coupon rate of 7%.
After-Tax Cost of Debt for Falcon Footwear = 0.07 × (1 − 0.4) = 0.042 or 4.2%
Key Takeaways
The debt component has important considerations.
- Tax considerations are important as interest payments are tax deductible.
- We can estimate the cost of debt either by looking at the market or by looking at our historical debt issuances.
Exercises
- What's the cost of debt if the company has $20 million in 20 year debt that pays 11% and they are in the 40% tax bracket?
- What's the cost of debt if the company has $50 million in 10 year debt that pays 6% and they are in the 40% tax bracket?