Calculating the Cost of Debt — Transcript

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1. 0:01now let's concentrate on how we
2. 0:03calculate the cost of
3. 0:06debt the before tax cost of debt would
4. 0:09be the yield to maturity of the bonds
5. 0:12notice that it is the yield to maturity
6. 0:14not necessarily the coupon
7. 0:16rate the after tax cost of debt would be
8. 0:19that before tax cost of debt times 1
9. 0:21minus the tax rate the reason why we
10. 0:25have to adjust for taxes is that the
11. 0:28interest is tax deductible but the other
12. 0:30sources of
13. 0:31capital uh do not or the uh the returns
14. 0:36to the investors of the other sources of
15. 0:37capital are not tax deductible namely
16. 0:40the dividends so because the tax code
17. 0:42gives preference to interest we have to
18. 0:44account for that that basically the
19. 0:46government
20. 0:47subsidizes that
21. 0:50expense on uh the
22. 0:52debt now recall that the free cash flows
23. 0:55when we calculated the net present value
24. 0:57of projects did not include the interest
25. 0:59expense and therefore couldn't account
26. 1:01for the deductibility of Interest so
27. 1:05we're handling that now in the weighted
28. 1:07average cost of capital which will
29. 1:09discount those cash flows for example we
30. 1:13have a firm with these bonds 10%
31. 1:16semiannual coupon bonds um each with a
32. 1:19par value of $1,000 and they all mature
33. 1:22in 20 years one Bond sells for $840
34. 1:25corporate tax rates 21% we want to
35. 1:28calculate ultimately the after tax cost
36. 1:29cost of debt so this is a review from
37. 1:32bonds how you would calculate the yield
38. 1:35to maturity we would input these values
39. 1:38into the financial
40. 1:40calculator to get the discount rate
41. 1:44which would
42. 1:45be on a six-month basis because these
43. 1:47are semiannual periods we need to
44. 1:49remember to annualize to get a before
45. 1:52tax cost of debt of
46. 1:5512.15% we multiply the before tax cost
47. 1:59of debt by 1 minus the tax rate giving
48. 2:02us an after tax cost of debt of 99.6%