Calculating the Debt Component of Cost of Capital

The firm’s cost of debt capital (before-tax and flotation cost) is set by the minimum rate of return

required by the creditors who are willing to purchase the firm’s debt instruments.

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Mathematically, this cost equals the present value of all interest payments plus the principal

repayment and is essentially the bond formula. This formula works the same way for straight

debt and for the issuance of bonds assuming, for simplicity, that the principal repayment is at the

last period.

To properly compute the firm’s cost of debt capital, we must adjust the previously developed

bond formula for two factors – tax deductibility and flotation costs. First, because interest

payments are tax deductible by the firm, the after-tax cost of debt (ki) must be computed as

follows:

ki = kd (1 – Tc)

where:

kd = coupon or stated interest rate

Tc = marginal corporate tax rate

Next, remembering that the net proceeds the firm actually receives (NPd) for either a bond or

note must be reduced by any issuance costs (flotation costs):

NPd = (net proceeds – flotation costs)

Substituting these new terms into the bond formula yields:

(math formula)

or

(financial table formula)

Sample Computation of the Debt Component of Cost of Capital (ki)

Alpha sells \$100 million worth of 20-year 7.8% coupon bonds. The net proceeds (proceeds after

flotation costs) are \$980 for each \$1,000 bond. Alpha’s marginal tax rate is 40%. What is the cost

of capital for this debt financing?

NPd = \$980 (The implied flotation cost is \$20 per bond.)

coupon (interest) rate = 7.8%

\$I = \$78 [(.078)(\$1,000)]

\$M = \$1000

n = 20 years

T = 40%

First solve for kd

Then solve for ki or kd (after tax).

kd = 8.0038

ki (after tax) = kd(1 – Tc ) = (8.0038)(1 – .40) = 4.8%

Cost of Capital—Preferred Stock Financing

The sources of preferred stock financing are:

• large financial institutions

• preferred equity market

• private investors