Reference no: EM131185060

Determining the Cost of Capital: Cost of Debt

A firm's before-tax cost of debt, rd, is the interest rate that the firm must pay on -Select-outstandingsecurednewItem 1  debt. Because interest is tax deductible, the relevant cost of -Select-outstandingsecurednewItem 2  debt used to calculate a firm's WACC is the -Select-after-taxbefore-taxItem 3  cost of debt, rd (1 – T). The -Select-after-taxbefore-taxItem 4 cost of debt is used in calculating the WACC because we are interested in maximizing the value of the firm's stock, and the stock price depends on -Select-after-taxbefore-taxItem 5  cash flows. It is important to emphasize that the cost of debt is the interest rate on -Select-outstandingnewItem 6  debt, not -Select-outstandingnewItem 7  debt because our primary concern with the cost of capital is its use in capital budgeting decisions. The rate at which the firm has borrowed in the past is -Select-relevantirrelevantItem 8  because we need to know the cost of -Select-outstandingsecurednewItem 9  capital. For these reasons, the -Select-current yield rateyield to maturitycoupon interest rateItem 10  on outstanding debt (which reflects current market conditions) is a better measure of the cost of debt than the -Select-current yield rateyield to maturitycoupon interest rateItem 11 . The -Select-current yield rateyield to maturitycoupon interest rateItem 12  on the company's -Select-longshortItem 13 -term debt is generally used to calculate the cost of debt because more often than not, the capital is being raised to fund -Select-longshortItem 14 -term projects.

Quantitative Problem: 5 years ago, Barton Industries issued 25-year noncallable, semiannual bonds with a $2,100 face value and a 9% coupon, semiannual payment ($94.5 payment every 6 months). The bonds currently sell for $845.87. If the firm's marginal tax rate is 40%, what is the firm's after-tax cost of debt? Round your answer to 2 decimal places. Do not round intermediate calculations.

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