Long-Term Financial Decisions

The value of a bond is found as the present value of interest payments plus

Then we can use the following formula to calculate the WACC. The cost of debt is taken to be on an after tax basis to further to account for the depreciation tax shield.

What is the correct capital structure and weighted average cost of capital for discounting the investment’s free cash flow?

9. What is the Cost of Debt, before and after taxes? Using the interest rate for the largest debt…cannot use the weighted interest rate for the debt since it includes capital lease obligations with no stated rate and could not find in the notes to the financials. 5.4% After tax cost is .054 x (1-.36) = 3.5%

The 8 percent pre-tax estimate is the nominal cost of debt. Because the firm's debt has semiannual coupons, its effective annual cost rate is 8.16 percent

D* = 3.59/1.053 = 3.41 years Learning Objective: 11-02 Compute the duration of bonds; and use duration to measure interest rate sensitivity.

- The Bet-r-Bilt Company has a 5-year bond outstanding with a 4.30 percent coupon. Interest payments are paid semi-annually. The face amount of the bond is $1,000. This bond is currently selling for 93 percent of its face value. What is the company's pre-tax cost of debt?

c. Should the nominal cost of Debt or the effective annual rate be used? Since the bond pays a coupon semi-annually, and earns 4.75% in six months, it is possible to determine the effective annual rate (EAR), which we have successfully calculated above. EAR = 6.6% Nevertheless, nominal rates are typically used for the cost of debt, because total costs of issuance and sale of securities decrease the net proceeds from the sale. These costs are naturally small on public debt issues.

The tax rate is estimated from case Exhibit 2 as Income Taxes ($496 million) divided by Earnings Before Taxes, Non-controlling Interest and Goodwill Amortization ($990 million). Note that, in 2001, interest on the company’s total debt is approximately 3.8%: $317 million of interest / $8,361 million of debt. However, this calculation is misleading since the 2000 debt is much larger than the 1999 debt of $2,270 (not in the case). You should ask yourself…should you use current yields or historical yields when calculating the cost of debt? Current yield figures should be used because Telus is considering

Cost of Equity = Risk free rate + (Market return – risk free rate) X beta

Calculate the after tax cost of debt using the following information (hint: see page 285 in text).

Government interest rates from Table B, 8.72%. The 10 year rate was chosen to be consistent with time lengths. Then the value for equity, debt and the firm need to be calculated, this is a simple step. The market price of the shares is multiplied by the number of outstanding shares to find the value of equity and the book value of long term debt is used for the value of debt and the value of both equity and debt are added together to come up with the value of the firm. The weight of the equity and debt can now be calculated by dividing the value of equity or debt by the value of the company. Lastly, the tax rate was calculated by using the balance sheet, given in exhibit 1, to determine income taxes paid and dividing it by earnings before interest and taxes for each of the last ten years then by taking the average of the ten years tax rates.

b. Generate a graph or table showing how the bond’s present value changes for semi-annually compounded interest rates between 1% and 15%.

The market value of debt was calculated using the existing yield of maturity on a 5 yar bond issued on a private placement basis on July 1, 2000. With the coupon of 5.75% and the discount price of 97, YTM for this bond is 6.62%. With a discount price being 97, the market value of debt is 17,654M.

The cost of debt (kd) rate of 13% was used after we assessed the key industrial financial ratios and compared them with that of Wrigley’s (See Appendix 2) to conclude that it was in the range between the BB rate of