Which debt rates to used when calculate WACC

CFA Level I Corporate Finance
#1

People can someone tell me which before tax cost of debt i have to use to calculate Wacc if i have multiple bonds outstanding. I think i have to use the YTM of the last bond the company issue, its is correct ?

Thank you

#2

That’s what I’d use.

#3

Thank you s2000magician

#4

My pleasure.

#5

Im not sure if it’s something different from the CFAI curriculum, but I was under the impression you could (as another method) take a weighted average of the YTMs on outstanding debt to estimate the cost of debt for a company. What are your experiences/thoughts with this?

#6

That seems like a reasonable approach.

In fact, the curriculum doesn’t specify how to choose (or calculate) the pre-tax cost of debt.

#7

From the practice I can tell that the weighted average cost of all the the outstanding debt is what you see quite often as an approximation. (However you might argue that theoretically you schould take the marginal cost of debt.)

Best,

Oscar

#8

Oscar and S2000:

I remember I was instructed to use the weighted average method in a case report I did in my MS Finance program, so I figured there was probably some validity to it as an estimation method for the cost of debt.

Thanks!

#9

My pleasure.

Things are somewhat simplified for the CFA exams, of course; they haven’t time to calculate the weighted average of a bunch of YTMs to get the pre-tax cost of debt, and that isn’t the point of the LOS anyway.

Oscar: you’re correct: it’s the marginal cost of debt that we want.

#10

I think the marginal cost of debt must be used, because that debt is the funding amount for the project you are valorizing. If you have multiple debts for the same project you would calculate the weighted cost of all debts involved which are marginal of your debt structure also.

#11

In the real world, I’d agree with you.

On the exam, it won’t be nearly that difficult: they’ll give you the number to use.

#12

We all hope so lol !

#13

Remember what I wrote above: the curriculum doesn’t specify how to choose or calculate it.

They have to give it to you.

#14

Came across this problem in the CFAI curriculum and I do not understand why they used the coupon rate for this cost of debt calculation:

Question is:

Two years ago, a company issued $20 million in long-term bonds at par value with a coupon rate of 9 percent. The company has decided to issue an additional $20 million in bonds and expects the new issue to be priced at par value with a coupon rate of 7 percent. The company has no other debt outstanding and has a tax rate of 40 percent. To compute the company’s weighted average cost of capital, the appropriate after-tax cost of debt is closest to:

  1. 4.2%.
  2. 4.8%.
  3. 5.4%.

They are saying 4.2% is the answer; however, their math to get to this answer is (.07(1-.4))= .042=4.2%

Any idea on why they are using the coupon rate rather than YTM?

Thanks

#15

Because YTM = coupon rate on a bond issued at par.

Try the following on your calculator:

PV = 100, PMT = 10, N = 10, FV = 100 and solve for I/Y = ?

The answer is 10%, the same as the coupon rate.

#16

Perfect . . . Makes sense now!

Thanks, Harrogath!

#17

Nice…