• Cost of Debt
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Mergers and acquisitions - Financing options
It consumes financial slack, may
decrease debt rating and increase cost
of debt. Transaction costs include
underwriting or closing costs of 1% to
3% of the face value.
1
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Mergers and acquisitions - Financing options
1
Issue of stock: it increases financial slack,
may improve debt rating and reduce cost
of debt. Transaction costs include fees for
preparation of a proxy statement, an
extraordinary shareholder meeting and
registration.
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Mergers and acquisitions - Financing options
Shares in treasury: it increases
financial slack (if they don’t have to be
repurchased on the market), may
improve debt rating and reduce cost of
debt. Transaction costs include
brokerage fees if shares are
repurchased in the market otherwise
there are no major costs.
1
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Economics of new nuclear power plants - Capital costs
1
Some analysts argue (for example Steve Thomas,
Professor of Energy Studies at the University of
Greenwich in the UK, quoted in the book The
Doomsday Machine (2012 book)|The Doomsday
Machine by Martin Cohen and Andrew McKillop ]) that
what is often not appreciated in debates about the
economics of nuclear power is that the cost of equity,
that is companies using their own money to pay for
new plants, is generally higher than the cost of
debt.The Doomsday Machine, Cohen and McKillop
(Palgrave 2012) page 199 Another advantage of
borrowing may be that once large loans have been
arranged at low interest rates - perhaps with
government support - the money can then be lent out
at higher rates of return.
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Merger - Financing options
*It consumes financial slack, may
decrease debt rating and increase cost
of debt. Transaction costs include
underwriting or closing costs of 1% to
3% of the face value.
1
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Merger - Financing options
1
*Issue of stock: it increases financial
slack, may improve debt rating and
reduce cost of debt. Transaction costs
include fees for preparation of a proxy
statement, an extraordinary
shareholder meeting and registration.
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Merger - Financing options
1
*Shares in treasury: it increases financial
slack (if they don’t have to be repurchased
on the market), may improve debt rating
and reduce cost of debt. Transaction costs
include brokerage fees if shares are
repurchased in the market otherwise there
are no major costs.
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Corporate finance - Capitalization structure
The cost of equity (see Capital asset pricing
model|CAPM and arbitrage pricing theory|APT)
is also typically higher than the cost of debt which is, additionally, a deductible expense –
and so equity financing may result in an
increased hurdle rate which may offset any
reduction in cash flow risk.See:[
http://www.lawyersclubindia.com/articles/Opti
mal-Balance-of-Financial-Instruments-LongTerm-Management-Market-Volatility-ProposedChanges-3765.asp Optimal Balance of Financial
Instruments: Long-Term Management, Market
Volatility Proposed Changes], Nishant
Choudhary, LL.M
1
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Leverage (finance) - Worked example
1
Interest rate differential = Return on investment less
Cost of debt = 5% - 4% = 1%
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Business valuation - Weighted average cost of capital (WACC)
1
The weighted average cost of capital is
an approach to determining a discount
rate. The weighted average cost of
capital|WACC method determines the
subject company’s actual cost of capital
by calculating the weighted average of
the company’s interest (finance)|cost of
debt and cost of stock|equity. The
weighted average cost of capital|WACC
must be applied to the subject
company’s net cash flow to total invested
capital.
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Modigliani-Miller theorem - Proposition II
1
* r_D is the required rate of return
on borrowings, or cost of debt.
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Working capital management - Capitalization structure
The cost of equity (see Capital asset pricing
model|CAPM and arbitrage pricing theory|APT) is
also typically higher than the cost of debt - which
is, additionally, a deductible expense – and so
equity financing may result in an increased hurdle
rate which may offset any reduction in cash flow
risk.See:[http://www.lawyersclubindia.com/articles/
Optimal-Balance-of-Financial-Instruments-LongTerm-Management-Market-Volatility-ProposedChanges-3765.asp Optimal Balance of Financial
Instruments: Long-Term Management, Market
Volatility Proposed Changes], Nishant Choudhary,
LL.M
1
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Time value of money - Calculations
1
The rate of return in the calculations can
be either the variable solved for, or a
predefined variable that measures a
discount rate, interest, inflation, rate of
return, cost of equity, cost of debt or any
number of other analogous concepts. The
choice of the appropriate rate is critical to
the exercise, and the use of an incorrect
discount rate will make the results
meaningless.
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History of private equity and venture capital - SL and the shutdown of the Junk Bond
Market
1
This made the cost of debt in the high
yield market significantly more expensive
than it had been previously.Altman,
Edward I
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Convertible bond - Valuation
1
A simple method for calculating the
value of a convertible involves
calculating the present value of future
interest and :wikt:principal|principal
payments at the cost of debt and adds
the present value of the warrant
(finance)|warrant
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Working capital management - Capitalization structure
The cost of equity (see Capital asset pricing
model|CAPM and arbitrage pricing theory|APT) is
also typically higher than the cost of debt - which
is, additionally, a deductible expense – and so
equity financing may result in an increased hurdle
rate which may offset any reduction in cash flow
risk.See:[http://www.lawyersclubindia.com/articles/
Optimal-Balance-of-Financial-Instruments-LongTerm-Management-Market-Volatility-ProposedChanges-3765.asp Optimal Balance of Financial
Instruments: Long-Term Management, Market
Volatility Proposed Changes], Nishant Choudhary,
LL.M
1
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Undercapitalization - Capital sources
1
* Debt is more expensive. The cost of
debt is lowest with secured, long-term
loans or use of personal savings,
higher with unsecured loans, credit
card loans and cash advances, and
with factoring (finance)|factoring
accounts receivable.
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Tax shield - Case B
The reason that he was able to earn
additional income is because the cost
of debt (i.e. 8%) is less than the return
earned on the investment (i.e. 10%).
The 2% difference makes income of
$80 and another $100 is made by the
return on equity capital. Total income
becomes $180 which becomes taxable
at 20%.
1
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Adjusted present value
Technically, an APV valuation model
looks similar to a standard Discounted
cash flow|DCF model. However, instead
of weighted average cost of
capital|WACC, cash flows would be
discounted at the unlevered cost of
equity, and tax shields at either the cost
of debt (Myers) or following later
academics also with the unlevered cost
of
1
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Adjusted present value - APV formula
1
The discount rate used in the second part is the
cost of debt financing by period.
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Adjusted present value - APV formula
1
+ Present Value of Debt's Periodic Interest Tax
Shield discounted by Cost of Debt Financing %
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Cost of capital - Summary
1
A company's securities typically include
both debt and equity, one must therefore
calculate both the cost of debt and the
cost of equity to determine a company's
cost of capital
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Cost of capital - Summary
For companies with similar risk or Bond
credit rating|credit ratings, the interest rate
is largely exogenous (not linked to the cost
of debt), the cost of equity is broadly
defined as the risk-weighted projected
return required by investors, where the
return is largely unknown
1
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Cost of capital - Summary
1
Once cost of debt and cost of equity
have been determined, their blend,
the weighted-average cost of capital
(WACC), can be calculated. This
WACC can then be used as a Annual
effective discount rate|discount rate
for a project's projected cash flows.
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Cost of capital - Cost of debt
1
Since in most cases debt expense is a
deductible expense, the cost of debt is
computed as an after tax cost to make
it comparable with the cost of equity
(earnings are After Taxes|after-tax as
well)
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Cost of capital - Cost of debt
1
The yield to maturity can be
used as an approximation of
the cost of debt.
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Merger and acquisitions - Financing options
1
*Issue of debt: It consumes financial slack,
may decrease debt rating and increase
cost of debt. Transaction costs include
underwriting or closing costs of 1% to 3%
of the face value.
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Return on equity - The DuPont formula
1
So if the firm takes on too much debt, the
cost of debt rises as creditors demand a
higher risk premium, and ROE
decreases.Woolridge, J
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Bankruptcy costs
In the Trade-Off Theory of capital
structure, firms are supposedly choosing
their level of debt financing by trading off
these bankruptcy costs of debt against tax
benefits of debt. In particular, a firm that is
trying to maximize the value for its
shareholders will equalize the marginal
cost of debt that results from these
bankruptcy costs with the marginal benefit
of debt that results from tax benefits.
1
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Countrywide Financial Corporation - Secondary market disruption
1
There can be no assurance, however, that
the Company will be successful in these
efforts, that such facilities will be adequate
or that the cost of debt will allow us to
operate at profitable levels.
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Hamada's equation
1
# The discount rate used to calculate the
tax shield is assumed to be equal to the
cost of debt capital (thus, the tax shield
has the same risk as debt). This and the
constant debt assumption in (1) imply that
the tax shield is proportionate to the
market value of debt: Tax Shield = T×D.
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Public-private partnerships - Controversy
Making a simple comparison,
however, between the government’s
cost of debt and the private-sector
WACC implies that the government
can sustainably fund projects at a cost
of finance equal to its risk-free
borrowing rate
1
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Pecking Order Theory - Theory
1
This does not however apply to high-tech
industries where the issue of equity is
preferable due to the high cost of debt
issue as assets are intangible Brealey RA,
Myers SC, and Allen F (2008)
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Cost of debt - Cost of debt
1
Since in most cases debt expense is a
deductible expense, the cost of debt is
computed as an after tax cost to make it
comparable with the cost of equity
(earnings are after-tax as well)
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Weir Group - History
WorthingtonSimpson was
profitable, but did
not cover the cost of
debt.
1
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Affordability of housing in Canada - Market-based affordability
1
Mortgage lending institutions define
affordability in terms of potential
home buyers consider the relative cost
of debt based on interest rates and
average household incomes
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