BF3326 Corporate Finance

The Cost of Debt & WACC

Funding for Companies
Capital of a
Corporate Source of Fund
company
Money invested by the
Borrowing
owners

Long-term Shares, Stock or Equity

Bonds bank loans
Still a puzzle….
Why not 100% debt?
Two counterbalancing forces:
– cost of financial distress
• As debt increases, probability of financial problem increases
• The extreme case is bankruptcy.
• Financial distress might be costly
– agency costs
• Conflicts of interest between shareholders and debtholders
(more on this later in the Merton model)
The trade-off theory suggests that these forces leads to a debt ratio
that maximizes firm value
Determinants of leverage
Tangibility of assets: Fixed Assets/Total Assets Debt
• Collateral => lower agency cost of debt
• More value in liquidation
Market to book Debt
• Growth opportunities - underinvestment
• Costs of financial distress
Size Debt
• Lower probability of bankruptcy
• Less asymmetry of information
Profitability
• profitable companies prefer internal funds
The Capital Structure Decision
With the capital structure decision, the financial manager decides from
where best to acquire monies long-term. The purchase of that new delivery
truck with cash or with a loan from GMAC or Ford Motor Credit is a capital
structure decision; the use of long-term borrowing to fund a franchise
purchase is another.

Perhaps most importantly, the decision to fund a firm’s growth with equity -
such as with funds invested by the firm’s founders, angel investors, venture
capitalists or public stock offerings – or debt, is a critical capital structure
choice. Two features of this choice bear mentioning:

• The risk of the debt

• The loss of control and reduced potential cash flows to the founders with
an equity or stock sale
Estimating the Individual Cost of Capital

The Cost of Debt

 The cost of debt is the rate of return the firm’s lenders demand when they
loan money to the firm.
 Note, the rate of return is not the same as coupon rate, which is the rate
contractually set at the time of issue.
 We can estimate the market’s required rate of return by examining the
yield to maturity on the firm’s debt.
 After-tax cost of debt = Yield (1-tax rate)
The Cost of Debt

It is not easy to find the market price of a specific bond as most bonds do not
trade in the public market.

Because of this, it is a standard practice to estimate the cost of debt using the
average yield to maturity on a portfolio of bonds with similar credit rating and
maturity as the firm’s outstanding debt.

The average yield to maturity for a specific rating class varies over time. It can
also differ across different industry groups.
Bond Ratings
The Cost of Debt

Bond Ratings
Capital Structure Effects

The impact of capital structure on value depends upon

the effect of debt on:

– WACC
– FCF
The Effect of Additional Debt on WACC

Debtholders have a prior claim on cash flows relative to stock

holders.
– Debtholders’ “fixed” claim increases risk of stockholders’ “residual” claim.
– Cost of stock, rs, goes up.

Firm’s can deduct interest expenses.

– Reduces the taxes paid
– Frees up more cash for payments to investors
– Reduces after-tax cost of debt
The Effect on WACC

• Debt increases risk of bankruptcy

– Causes pre-tax cost of debt, rd, to increase

• Adding debt increase percent of firm financed

with low-cost debt (wd) and decreases percent
financed with high-cost equity (we)
• Net effect on WACC = uncertain.
Asymmetric Information and Signaling

• Managers know the firm’s future prospects better than investors.

• Managers would not issue additional equity if they thought the

current stock price was less than the true value of the stock
(given their inside information).

• Hence, investors often perceive an additional issuance of stock

as a negative signal, and the stock price falls.
Factors That Influence Business Risk

• Uncertainty about demand (unit sales).

• Uncertainty about output prices.
• Uncertainty about input costs.
• Product and other types of liability.
• Degree of operating leverage (DOL).
Business Risk versus Financial Risk
Business risk:
– Uncertainty in future EBIT.
– Depends on business factors such as competition, operating leverage,
etc.

Financial risk:
– Additional business risk concentrated on common stockholders when
financial leverage is used.
– Depends on the amount of debt and preferred stock financing.
Wealth of Shareholders

• Value of the equity declines as more debt is issued,

because debt is used to repurchase stock.

• But total wealth of shareholders is value of stock after the

recapitalization plus the cash received in repurchase,
and this total goes up.
Factors Effecting Capital Structure

• Debt ratios of other firms in the industry.

• Pro forma coverage ratios at different capital structures under

different economic scenarios.

• Lender and rating agency attitudes

(impact on bond ratings).
Cost of Debt Consideration

• Reserve borrowing capacity.

• Effects on control.

• Type of assets: Are they tangible, and hence suitable as collateral?

• Tax rates.
Cost of Debt

The cost of debt capital to the firm is the rate

of return required by a firm’s creditors.
Yield to maturity (YTM)

• Yield to maturity (YTM) is the interest rate (i) that

equates the present value of cash flow payments
received from a debt instrument with its value
today.

• the most accurate measure of interest rates.

Debt / Bond Valuation
 Bond Valuation is an application of Present Value.
 The Value of the bond is the present value of all the cash flows the
investor receives as a result of holding the bond.
 3 Cash Flows
 Amount that is paid to purchase the bond (PV)
 Periodic Interest Payments made to the bondholders (PMT)
 Payment of maturity value at end of Bond’s life.
 Other Terminology
 Time frame for cash flows (N) = Bond’s Maturity
 Interest Rate for Time Value is the rate at which future cash flows are being
discounted to present.
Cost of Debt

For a debt issue, this rate of return, kd, equates the

present value of all expected future receipts—interest, I,
and principal repayment, M—with the net proceeds, pnet,
of the debt security:
n
I M
Pnet   
t 1 (1  kd ) (1  kd ) n
t

Pnet  I (PVIFA kd ,n )  M (PVIFkd ,n )

The Cost of Debt

What will be the yield to maturity on a debt that has par value of
$1,000, a coupon interest rate of 5%, time to maturity of 10 years and
is currently trading at $900? What will be the cost of debt if the tax rate
is 30%?

 We can calculate yield to maturity of the bond YTM=6.38%.

 After-tax cost of debt = YTM(1-Tax Rate)=6.38%(1-.3)=4.47%
Cost of Debt

The pre-tax cost of debt, kd, is calculated in the same way as the
yield to maturity. The only difference in the calculation is that when
making yield-to-maturity calculations, the price of the bond is the
current market price. When computing the pretax cost of debt to a
company, the price of the bond is the net proceeds the company
receives after considering all issuance costs.
Cost of Debt
Interest payments made to investors are deductible from the
firm’s taxable income. Therefore, the after-tax cost of debt, ki,
is computed by multiplying the pre-tax cost of debt, kd, by 1
minus the firm’s marginal tax rate, T: ki = kd(1 – T)

– The tax benefits of interest deductibility are available only to firms that
are making profits.
– For a firm losing money, the after-tax cost, ki, is the same as the pretax
cost, kd.
Cost of Debt

Assume that KMI sells $100 million of 20-year 7.8 percent

coupon rate bonds. The net proceeds to KMI after issuance
costs are $980 for each $1,000 bond. KMI’s pretax cost, kd,
of this debt offering can be calculated as follows:

980  $78(PVIFAkd ,20 )  $1, 000(PVIFkd ,20 )

Cost of Debt

The calculation of kd can be done either by trial and error using Tables or
with the aid of a financial calculator.

– By trial and error, try 8 percent:

$980 = $78(9.818) + $1,000(0.215)

– 20 → N
-980 → PV
78 → PMT
1000 → FV
Compute
i% (= 8.00)
Cost of Debt

Assuming a 40 percent marginal tax rate, the after-tax cost of debt for KMI is:

ki = kd(1 – T) = 8%(1 – 0.4) = 4.8%

Cost of Debt

A 5-year, 12% annual coupon bond sells for $1,075.81. What is the
cost of debt (rd)?

INPUTS 5 -1075.81 120 1000

N I/YR PV PMT FV
OUTPUT 10
Cost of Debt

Interest is tax deductible, so

After-Tax rd
= Before Tax rd (1-T)
= 10% (1 – T)
If T=40%
= 6%
Cost of Debt Zero Coupon

Assume that Basket Wonders (BW) has $1,000 par value

zero-coupon bonds outstanding. BW bonds are currently
trading at $385.54 with 10 years to maturity. BW tax bracket
is 40%.

$0 + $1,000
$385.54 =
(1 + kd)10
Cost of Debt Zero Coupon

(1 + kd)10 = $1,000 / $385.54

= 2.5938
(1 + kd) = (2.5938) (1/10)
= 1.1

kd = 0.1 or 10%
ki = 10% ( 1 – .40 )

ki = 6%
The Weighted Average Cost of Capital

• We can use the individual costs of capital that we have computed

to get our “average” cost of capital for the firm.

• This “average” is the required return on the firm’s assets, based on

the market’s perception of the risk of those assets

• The weights are determined by how much of each type of financing

is used
Capital Structure Weights
Notation
– E = market value of equity = # of outstanding shares times price per
share
– D = market value of debt = # of outstanding bonds times bond price
– V = market value of the firm = D + E

Weights
– wE = E/V = percent financed with equity
– wD = D/V = percent financed with debt
Capital Structure Weights

Suppose you have a market value of equity

equal to $500 million and a market value of debt
equal to $475 million.

– What are the capital structure weights?

• V = 500 million + 475 million = 975 million

• wE = E/V = 500 / 975 = .5128 = 51.28%
• wD = D/V = 475 / 975 = .4872 = 48.72%
Taxes and the WACC
• We are concerned with after-tax cash flows, so we also need to
consider the effect of taxes on the various costs of capital
• Interest expense reduces our tax liability

– This reduction in taxes reduces our cost of debt

– After-tax cost of debt = RD(1-TC)

• Dividends are not tax deductible, so there is no tax impact on the

cost of equity

• WACC = wERE + wDRD(1-TC)

WACC

Equity Information Debt Information

– 50 million shares
– $80 per share
– Beta = 1.15
– Market risk premium = 9%
– Risk-free rate = 5%
– $1 billion in outstanding
debt (face value)
– Current quote = 110
– Coupon rate = 9%,
semiannual coupons
– 15 years to maturity

Tax rate = 40%

WACC
What is the cost of equity?
– RE = 5 + 1.15(9) = 15.35%

What is the cost of debt?

– N = 30; PV = -1,100; PMT = 45; FV = 1,000; CPT I/Y = 3.9268
– RD = 3.927(2) = 7.854%

What is the after-tax cost of debt?

– RD(1-TC) = 7.854(1-.4) = 4.712%
WACC
What are the capital structure weights?
– E = 50 million (80) = 4 billion
– D = 1 billion (1.10) = 1.1 billion
– V = 4 + 1.1 = 5.1 billion
– wE = E/V = 4 / 5.1 = .7843
– wD = D/V = 1.1 / 5.1 = .2157

What is the WACC?

– WACC = .7843(15.35%) + .2157(4.712%) = 13.06%
Divisional and Project Costs of Capital

• Using the WACC as our discount rate is only appropriate for

projects that have the same risk as the firm’s current operations

• If we are looking at a project that does NOT have the same risk as
the firm, then we need to determine the appropriate discount rate
for that project

• Divisions also often require separate discount rates

Comprehensive Problem

• A corporation has 10,000 bonds outstanding with a 6% annual coupon

rate, 8 years to maturity, a $1,000 face value, and a $1,100 market price.

• The company’s 100,000 shares of preferred stock pay a $3 annual

dividend, and sell for $30 per share.

• The company’s 500,000 shares of common stock sell for $25 per share
and have a beta of 1.5. The risk free rate is 4%, and the market return is
12%.

• Assuming a 40% tax rate, what is the company’s WACC?