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taco bell
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1. SIVMED’s estimated weighted average cost of capital includes the following capital components: cost of debt (kd), cost of common stock (kcs) and cost of preferred stock (kps). In computation of WACC the values should be after-tax because for instance the interest paid to obtain debt is tax deductible. For a firm that encountered losses the tax rate is zero, so the after-tax cost of debt equals the interest rate. New (marginal) values should be used in computation of WACC because in financial management the WACC s used primarily to make investment decisions, and these decisions hinge on projects’ returns vs. the cost of new capital. The historical cost is important to a certain extent: the average cost of all capital raised in the past and still outstanding is used by regulators when they determine the rate of return a public utility should be allowed to earn, however the relevant cost is the marginal cost of new debt to be raised. 2. a) The cost of debt (kd) is: 6.6% as calculated below. First, we have calculated Yield to Maturity by using a financial calculator and the YTM is: 11% (5.5% semiannually) Before-tax cost of debt is 11% The tax rate is 40% After-tax cost of debt is: 11(1-.4) = 6.6% b) Typically, when calculating the cost of debt, the flotation cost which is the cost incurred to sell new bonds, is disregarded. And this is, in a large content, due to the fact that the vast majority of debt is privately placed and hence has no flotation cost associated with issuing new bonds. Also, the adjustment for flotation costs usually has a very small effect on the cost of debt. There are some situations when the flotation cost should be considered in the after-tax cost of debt. First is when the floatation costs are a large percentage of the cost debt. The second situation is when the bond’s life is short. c) The nominal cost of debt should be used, which is 11%. The effective annual rate implies the following formula: (1+0.11/2)2-1= 11.3% Most companies use the nominal rate for all component costs because WACC is used to discount the capital budgeting cash flows. The capital budgeting cash flows are considered to occur at the end of the year.
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