Accounting & Bookkeeping & Small Business Forum

1. ON WACC, I'm confused on what to use when trying to get the Cost of Debt! Sometimes they use the coupon rate, and other times they use the yield to maturity. I'm confused about which one to use!?

2. When the problem gives us pre-tax, or before tax, is that the number we should use, or are there other operations that should be done? (For instance, if they say "Its before-tax cost of debt is 12%" I should use 0.12 just like that, Or I should try to get the after-tax number by using the pre-tax that they just gave me? (I hope you understood my question!).

Thanks!

1. The true 'cost' of an outstanding debt issue, to the issuer, is the after-tax YTM. The coupon rate will equal the YTM only when the paper is trading at par, and that typically only occurs in rare coincidences. If you see a WACC calc using coupon rate, it's likely because the debt is trading very close to par, and the coupon rate is therefore a reasonable proxy, if precision isn't required.

2. Use the after-tax cost of debt. If you're given the pre-tax rate, find the issuer's tax rate somewhere. If you fail to account for the deductibility of the debt's interest, you'll significantly overstate the debt's true economic cost to the issuer. The exception to this general concept would be in cases where the issuer isn't expected to pay taxes anytime soon (e.g., big NOL carryforwards). In such situations you'd wanna use the pre-tax rate as the debt's cost, but also reduce it a bit for the present value of the (distant) interest tax shields. Having said that, though, I doubt you'll encounter this exception in your text--so stick with the primary rule of using the after-tax rate in your WACC calcs (while keeping the exception in the back of your mind).