12/7/2006
Chapter 10. Tool Kit for The Cost of Capital
To estimate NCC's cost of debt, use the RATE function to find the yield on the bonds:
Number of years to maturity
22
Number of payments per year
2
Annual coupon rate
9%
Face value
$1,000
N =
44
PV =
($835.42)
PMT =
$45
FV =
$1,000
5.500%
11.000%
Find the after-tax cost of debt for NCC's bonds is NCC is subject to a 40% marginal tax rate.
11%
Tax rate
40%
(1-Tax rate)
x
60%
x
11%
6.6%
Flotation Costs and the Cost of Debt
Number of years to maturity =
30
Tax rate =
40%
Flotation percentage cost (F) =
1%
The cost of capital is a vital element in the capital budgeting process.
For a project to be accepted, it must provide
a return that exceeds its cost of capital, or hurdle rate.
The cost of capital also serves three other purposes: (1) It is
used to help determine the EVA, (2) Managers use the cost of capital when deciding between buying and leasing,
and (3) the cost of capital is used in the regulation of electric, gas, and telephone companies.
The cost of capital is the weighted average cost of the debt, preferred stock, and common equity that the firm uses
to finance its assets, or its WACC. There is an overall, or corporate, WACC which reflects the average riskiness of
all the firm's assets.
However, since different assets may have more or less risk than the average, the overall
WACC must be adjusted up or down to reflect the riskiness of different proposed capital budgeting projects.
COST OF DEBT, r
d
(1 − T)
(Section 10.2)
The relevant cost of debt is the after-tax cost of new debt, taking account of the tax deductibility of interest.
The
after-tax calculated by multiplying the interest rate (or the before-tax cost of debt) times one minus the tax rate.
NCC has outstanding bonds with a 9 percent annual coupon rate, 22 years remaining until maturity, and a face
value of $1,000. The bonds make semiannual coupon payments and currently are trading in the market at a price
of $835.42.
I/YR = r
d
=
Annualized r
d
=
B-T r
d
A-T r
d
=
(B-T r
d)
A-T r
d
=
A-T r
d
=
NCC can issue a 30-year, $1,000 par value bond with a coupon rate of 11 percent, paid
semiannually.
The tax rate is 40%, and the flotation costs are 1% of the value of the issue.
A
B
C
D
E
F
G
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