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.
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