Essay on Cost of Capital

1830 Words Jul 26th, 2012 8 Pages

LEARNING GOALS: 1. Understand the key assumptions, the basic concept and the specific sources of capital associated with the cost of capital. 2. Determine the cost of long-term debt and the cost of preferred stock. 3. Calculate the cost of common stock equity and convert it into the cost of retained earnings and the cost of new issues of common stock. 4. Calculate the weighted average cost of capital (WACC) and discuss alternative weighing schemes. 5. Describe the procedures used to determine break points and the weighted marginal cost of capital (WACC). 6. Explain the weighted marginal cost of capital (WMCC) and its use with the investment opportunities schedule (IOS) to make
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Because of similar-risk bonds earn returns greater than 9%, the firm must sell the bonds for $980 to compensate for the lower coupon interest rate. The flotation costs are 2% of the par value of the bond.

Flotation Cost = .02 x $1000 = $20

Net Proceeds = $980 - $20 = $960

BEFORE-TAX COST OF DEBT The before tax cost of debt, rd, for a bond can be obtained in any three ways: quotation, calculation or approximation.

Approximating the Cost The before-tax cost of debt, rd, for a bond with a $1000 par value can be approximated by using the following equation:


rd= I + $1000 - Nd n Nd +$1000 2 Where: I= annual interest in dollars Nd= net proceeds from the sale of debt (bond) n = number of years to the bond’s maturity Substitution: rd= $90 + $1000 - $960 20 $960 +$1000 2 = $90 + $2 $980 = $92 $980 rd= 9. 4% AFTER-TAX COST OF DEBT The specific cost of financing must be stated on an after-tax basis. Because interest on debt is tax deductible, it reduces the firm’s taxable income. Formula: ri = rd x (1-T) Example: Duchess Corporation has a 40% tax rate. Using the 9.4% before-tax debt calculated above: ri = rd x (1-T) = 9.4% x (1-0.40) = 9.4% x 0.60 = 5.6% *

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