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Cost of Debt and Equity Capital
We start with the first input variable in the equation, the firm‟s cost of debt. Specifically, we will use
the interest rate the company would pay if it issued new debt capital right now. Recall that WACC is
used as the hurdle rate for current internal investment projects, so we need to use the current cost of
debt when calculating WACC. This cost of debt capital for any firm is the yield to maturity of its
bonds currently traded in the financial markets. If the firm‟s bonds are being bought and sold in
financial markets today at a price that yields, say, 8%, that tells us that 8% is the firm‟s current cost of
debt. Investors are willing to buy and hold the company‟s bonds at an 8% yield, so this number is the
firm‟s current cost of debt.
The yield to maturity for a company‟s traded bonds is reported by many financial information
sources. Mergent BondViewer is an excellent source of information about corporate bonds, and at the
time this chapter was written, Mergent reported that a long-term bond issued by the Walt Disney
Company that matures in March 2032 was being traded with a yield to maturity of 6.96%. Since
investors are willing to buy and hold Disney bonds at a 6.96% yield to maturity, this is Disney‟s
current cost of debt capital. One warning is necessary when determining cost of debt capital. It is
incorrect to use the coupon interest rate of a firm‟s bonds as the cost of debt, because that coupon
interest rate was set when the bond was sold at some earlier date. In the case of this particular Disney
bond, the coupon interest rate was set at 7% when the bond was issued in February 2002. Since
Disney issued bonds with a 7% coupon interest rate and investors purchased these bonds, it is accurate
to state that Disney‟s cost of debt was 7% when the bonds were issued. After the date of original issue,
financial market conditions changed; in fact, they change every day, and bond yields change as well.
Be sure to select the current yield to maturity of the company‟s traded bonds to determine its current
cost of debt capital.
Interest paid by companies on borrowed capital is deductible for income tax purposes. If a firm‟s
income tax rate is 40% and it pays $100 of tax deductible interest expense, taxable income is reduced
by $100, which reduces income taxes by $40, leaving an after-tax interest expense of $60. This is why
the cost of debt is multiplied by 1 minus the income tax rate when calculating WACC. The income tax
rate for a company can be found in its income statement, and for Disney, its income tax rate averaged
36% during the three reporting years from fiscal year 2006 through fiscal year 2008. With an income
tax rate of 36%, Disney‟s after-tax cost of debt is the current yield to maturity on its bonds, multiplied
by 1 minus the income tax rate of 36%.
Through our previous discussion of risk and return and the capital asset pricing model, we have
already determined that the cost of equity capital represented by Disney‟s common stock is 10.375%.
Given Disney‟s beta coefficient of 0.95, a market risk premium of 6.5%, and the risk-free rate of
return of 4.20%, the cost of equity capital provided by Disney common stockholders is 10.375%.
There is another category of equity capital, known as preferred stock, because it has preferences
over common stockholders with respect to dividends and liquidation. This means preferred
stockholders must receive their dividends before common stockholders are entitled to any dividend
payments, and if the firm fails and is liquidated, preferred stockholders receive the par value of their
shares before common stockholders receive any payments. Preferred stock dividends are stated as a
dollar amount per share, so a share of preferred stock with a $50 par value and a $3 dividend per share
earns a dividend yield of $3 ÷ $50 or 6.0% of par value.