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Which of the following is least likely to be useful to an analyst who is estimating the pretax cost of a firm’s fixed-rate debt?

A)	The coupon rate on the firm’s existing debt.

B)	The yield to maturity of the firm’s existing debt.

C)	Seniority and any special covenants of the firm’s anticipated debt.

Ideally, an analyst would use the YTM of a firm’s existing debt as the pretax cost of new debt. When a firm’s debt is not publicly traded, however, a market YTM may not be available. In this case, an analyst may use the yield curve for debt with the same rating and maturity to estimate the market YTM. If the anticipated debt has unique characteristics that affect YTM, these characteristics should be accounted for when estimating the pretax cost of debt. The cost of debt is the market interest rate (YTM) on new (marginal) debt, not the coupon rate on the firm’s existing debt. If you are provided with both coupon and YTM on the exam, you should use the YTM.

The debt of Savanna Equipment, Inc. has an average maturity of ten years and a BBB rating. A market yield to maturity is not available because the debt is not publicly traded, but the market yield on debt with similar characteristics is 8.33%. Savanna is planning to issue new ten-year notes that would be subordinate to the firm’s existing debt. The company’s marginal tax rate is 40%. The most appropriate estimate of the after-tax cost of this new debt is:

The after-tax cost of debt similar to Savanna’s existing debt is k_d(1 - t) = 8.33%(1 - 0.4) = 5.0%. Because the anticipated new debt will be subordinated in the company’s debt structure, investors will demand a higher yield than the existing debt carries. Therefore, the appropriate after-tax cost of the new debt is more than 5.0%.

The 6% semiannual coupon, 7-year notes of Woodbine Transportation, Inc. trade for a price of $94.54. What is the company’s after-tax cost of debt capital if its marginal tax rate is 30%?

To determine Woodbine’s before-tax cost of debt, find the yield to maturity on its outstanding notes:

PV = -94.54; FV = 100; PMT = 6 / 2 = 3; N = 14; CPT → I/Y = 3.50 × 2 = 7%

Woodbine’s after-tax cost of debt is k_d(1 - t) = 7%(1 - 0.3) = 4.9%

Ferryville Radar Technologies has five-year, 7.5% notes outstanding that trade at a yield to maturity of 6.8%. The company’s marginal tax rate is 35%. Ferryville plans to issue new five-year notes to finance an expansion. Ferryville’s cost of debt capital is closest to:

Ferryville’s cost of debt capital is k_d(1 - t) = 6.8% × (1 - 0.35) = 4.42%. Note that the before-tax cost of debt is the yield to maturity on the company’s outstanding notes, not their coupon rate. If the expected yield on new par debt were known, we would use that. Since it is not, the yield to maturity on existing debt is the best approximation.

Which of the following is most accurate regarding the component costs and component weights in a firm’s weighted average cost of capital (WACC)?

A)	The appropriate pre-tax cost of a firm’s new debt is the average coupon rate on the firm’s existing debt.

B)	Taxes reduce the cost of debt for firms in countries in which interest payments are tax deductible.

C)	The weights in the WACC should be based on the book values of the individual capital components.

The after-tax cost of debt = k_d(1 – t) = k_d – k_d(t), where k_d is the pretax cost of debt and t is the effective corporate tax rate. So the tax savings from the tax treatment of debt is k_d(t). Capital component weights should be based on market weights, not book values. And, the appropriate pre-tax cost of debt is the yield to maturity on the firm’s existing debt.