Cost of Debt
by MaestriThe first step in estimating the cost of debt is to determine the rate of return debtholders require, or rd. Although estimating rd is conceptually straightforward, some problems arise in practice. Companies use both fixed and floating rate debt, straight and convertible debt, and debt with and without sinking funds, and each form has a somewhat different cost.
It is unlikely that the financial manager will know at the start of a planning period the exact types and amounts of debt that will be used during the period: The type or types used will depend on the specific assets to be financed and on capital market conditions as they develop over time. Even so, the financial manager does know what types of debt are typical for his or her firm. For example, NCC typically issues commercial paper to raise short-term money to finance working capital, and it issues 30- year bonds to raise long-term debt used to finance its capital budgeting projects. Since the WACC is used primarily in capital budgeting, NCC’s treasurer uses the cost of 30- year bonds in her WACC estimate.
Assume that it is January 2003, and NCC’s treasurer is estimating the WACC for the coming year. How should she calculate the component cost of debt? Most financial managers would begin by discussing current and prospective interest rates with their investment bankers. Assume that NCC’s bankers state that a new 30-year, noncallable, straight bond issue would require an 11 percent coupon rate with semiannualpayments, and that it would be offered to the public at its $1,000 par value. Therefore, rd is equal to 11 percent.2
Note that the 11 percent is the cost of new, or marginal, debt, and it will probably not be the same as the average rate on NCC’s previously issued debt, which is called the historical, or embedded, rate. The embedded cost is important for some decisions but not for others. For example, the average cost of all the 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, in financial management the WACC is used primarily to make investment decisions, and these decisions hinge on projects’ expected future returns versus the cost of new, or marginal, capital. Thus, for our purposes, the relevant cost is the marginal cost of new debt to be raised during the planning period.
Taken From : Five-Minute MBA – Corporate Finance
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