Cost of Debt, (2)
by MaestriSuppose NCC had issued debt in the past, and its bonds are publicly traded. The financial staff could use the market price of the bonds to find their yield to maturity (or yield to call if the bonds sell at a premium and are likely to be called). The YTM (or YTC) is the rate of return the existing bondholders expect to receive, and it is also a good estimate of rd, the rate of return that new bondholders would require. If NCC had no publicly traded debt, its staff could look at yields on publicly traded debt of similar firms. This too should provide a reasonable estimate of rd.
The required return to debtholders, rd, is not equal to the company’s cost of debt because, since interest payments are deductible, the government in effect pays part of the total cost. As a result, the cost of debt to the firm is less than the rate of return required by debtholders.
The after-tax cost of debt, rd(1 T), is used to calculate the weighted average cost of capital, and it is the interest rate on debt, rd, less the tax savings that result because interest is deductible.
Flotation costs are usually fairly small for most debt issues, and so most analysts ignore them when estimating the cost of debt. Later in the chapter we show how to incorporate flotation costs for those cases in which they are significant.
Taken From : Five-Minute MBA – Corporate Finance
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