Question

1. Do we focus on after-tax cost of debt or before-tax cost of debt? Do we focus on new costs of debt or historical costs of debt? Why?

2. How to adjust component cost of debt, preferred stock, common stock for flotation costs?

3. When we calculate WACC, do we consider such current liabilities as accounts payable, accruals, and deferred taxes as sources of funding? Why?

Answer 1

1) The cost of debt is related to the interest rate that company pays on it's debt. We usually focus on after tax cost of debt as we want to consider the taxes to be taken into account. The deductible interest expense used to differentiate the before tax cost of debt and after-tax cost of debt.

We focus on the new cost of debt as it involves the decision of raising new debt and it's investment. Therefore, new (marginal) cost of debt is considered.

2)Floatation cost are those cost that are incurred at the time of raising an additional capital. Flotation cost generally depends on the type of capital being raised such as debt, equity or preference shares. Therefore, we must adjust the floatation cost incurred on raising debt, preference shares or equity.

Equity: the floatation cost is adjusted if the percentage is given against the price per share. The equation for calculating the external cost of equity (r_e) is

Here, f is the floatation cost

D1 is the dividend

P0 is the price per share

g is the growth rate

Preference share: The formula of floatation cost adjusted cost of preference share is :

K_p=D_p/NP

K_p is coast of preference shares

D_p is dividend on preference shares

NP is net proceeds arrived after deducting floatation cost from issue price.

Debt: The equation for floatation cost adjusted cost of debt is

Amount raised = funding needed / (1- percentage of floatation)

3)Weighted Average cost of capital (WACC) is like an opportunity cost that firm is ready to give up while undertaking a new project. Accounts payables, accruals, deferred taxes are part of the firm's obligations that firm cannot give up to undertake a project. Therefore, it is assumed that there is no opportunity cost. Thus, all these components of current liabilities acts like a short-term debt to companies which can be utilised for short term needs of the companies.