1. What specific items of capital should be included in the SIVMED’s WACC? Should before-tax or after-tax values be included? Should historical or new values be used? Why?
Answer: WACC covers computation of SIVMED’s cost of capital in which each category of capital is proportionately weighted. All capital basis - common stock, preferred stock, bonds or any other long-term borrowings – should be listed under SIVMED’s WACC. We determine WACC by multiplying the cost of the corresponding capital component by its proportional weight and then adding: where: Re is a cost of equity Rd is a cost of debt E is a market value of the firm's equity D is a market value of the firm's debt V equals E + D E/V is a proportion of financing that is equity D/V is a proportion of financing that is debt Tc is a corporate tax rate Broadly speaking, SIVMED’s assets are financed by the choice of debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, SIVMED can determine how much interest the company has to pay for every dollar it uses. Shareholders are interested into cash flows available to them, after corporate taxes have been paid. Consequently, we have to use After-Tax WACC. The cost of capital is used above all to make decisions that involve getting new capital. Hence, the applicable component costs are present marginal costs but not than historical costs.
2. What is your estimate of SIVMED’s cost of debt?
a. The cost of debt is the money company has to pay for using the funds. In our case, annual cost of debt is kd: kd/2 = r = 5.0%. kd/2 = (47.5 + [1000-891] / 30) / ((2*891 + 1000) / 3) = 5.5% We have to multiply this by 2 since we are dealing with semiannual payments, hence annual yield is 11%. Because interest is tax deductible, government pays part of the cost, and our component cost of debt is the after tax cost: kd (1-T) = 11% (1-0.4) = 11 * 0.6 = 6.6% b. Should flotation costs be included in the component cost of debt calculation? Flotation costs are typically included in the component of debt calculation as a part of calculating the nominal rate of the debt’ cost. The costs related to the process of getting new securities. Flotation costs cover both the underwriting spread and the costs paid by the issuing company from the offering. Shown as a portion of gross proceeds, costs usually rise as risks associated with the issue rise, or the size of the offering decreases. c. Should the nominal cost of Debt or the effective annual rate be used? Since the bond pays a coupon semi-annually, and earns 4.75% in six months, it is possible to determine the effective annual rate (EAR), which we have successfully calculated above. EAR = 6.6% Nevertheless, nominal rates are typically used for the cost of debt, because total costs of issuance and sale of securities decrease the net proceeds from the sale. These costs are naturally small on public debt issues. d. How valid in an estimate of the cost of debt based on 15 year bonds if the corporation normally issue 30 year long term debt? The estimate is not exactly valid because coupon rates differ for 15- and 30-year bonds. Generally, the cost of debt is higher for bonds with longer time to maturity. It has to do with risk. The longer the time to maturity, the higher the risk, hence, the higher the coupon rate (cost of debt in our case). In order to make the estimate more valid, the yield curve calculated for the 15-year bonds have to be adjusted for the 30-year bonds. e. Suppose SIVMED’s outstanding debt has not been recently traded, what other methods could be used to estimate the cost of debt? To determine the cost of debt for for the debt that has not been traded, we would calculate a synthetic rating based upon the company's financial ratios. In its most basic form, we are able to determine a synthetic rating for a company based upon its interest coverage...
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