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Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937

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Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937
Textbook Problem
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Next, we need to calculate MMM’s cost of debt. We can use different approaches to estimate it One approach is to take the company’s interest expense and divide it by total debt (which is the sum of short-term debt and long-term debt). This approach only works if the historical cost of debt equals the yield to maturity in today’s market (i.e., if MMM’s outstanding bonds are trading at dose to par). This approach may produce misleading estimates in years in which MMM issues a significant amount of new debt. For example, if a company issues a great deal of debt at the end of the year, the full amount of debt will appear on the year-end balance sheet, yet we still may not see a sharp increase in annual interest expense because the debt was outstanding for only a small portion of the entire year. When this situation occurs, the estimated cost of debt will likely understate the true cost of debt. Another approach is to try to find this number in the notes to the company’s annual report by accessing the company's home page and its Investor Relations section. Alternatively, you can go to other external sources, such as bondsonline.com, for corporate bond spreads, which can be used to find estimates of the cost of debt. Finally, you can also go to Morningstar.com, which will provide yield to maturity information on the firm’s various bond issues. A longer-term issue’s YTM could provide an estimate of the firm’s current cost of debt to be used in the WACC calculation. Remember that you need the after-tax cost of debt to calculate a firm's WACC, so you will need MMM’s tax rate (which has averaged around 30% in recent years). What is your estimate of MMM’s after-tax cost of debt?

Summary Introduction

To determine: Cost of debt after tax.

Introduction:

Cost of Debt:

Cost of debt is the proportion of interest which a company is liable to pay on its borrowed amount.

Explanation

From www.wsj.com,

Long-term debts of M Company are $55 million

Interest capitalized is $15 million.

The tax rate is 30%.

The formula to calculate the cost of debt:

Costofdebt after tax=Before tax cost of debt×(100%Incremental tax rate)

Substitute 27.27% for before-tax cost of debt and 30% for the tax rate.

Costofdebt after tax=27.27%×(100%30%)=27

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