Cost Of Capital And Capital Budgeting Harvard Case Solution & Analysis

Answer: 1

Determination of the Cost of Debt for a Company:

The cost of debt depends upon a lot of factors like the cost of issuing debts, time to maturity, rate of return of any previously issued bond, any discounts or premiums attached to the debt, any benefits or special characteristics (convertible, warrants etc.) related to the debt, type of debt (either redeemable or irredeemable / fixed or floating), tax rate of the company after issuance of debt and the company’s own credit rating. There is a difference between the investors required rate of return and the company’s cost of debt as the company benefit from tax deductions on interest paid as interest is a tax-deductible expense(Burney, n.d).

If the bonds are irredeemable than the cost of debt can be calculated as Interest payments divided by the Market Value of the debt. If the bonds are redeemable but the redemption value is same as the current market price than it is calculated in the same way as irredeemable debts. But if the redemption value differs from the current market value than Internal Rate of Return (IRR) is used in which bond price, interest payments (after tax) and the redemption value is discounted at two different rates and then using a formula IRR is computed. There are other methods too that can be used to calculate the cost of debt like credit spread along the credit rating of the company and CAPM when there is a certain risk involved relating to a particular debt.

Answer: 2

Difference between A Privately Placed and Publicly Traded Debt

Privately placed debts are available to a limited number of investors hence it is easy to renegotiate and saves the company from facing agency conflicts. They are very flexible as they can be easily adjusted according to the company’s requirements and have a low flotation cost as compared to the publicly traded ones. The company does not have to follow any SEC requirements to attain these type of debts so they are time saving and comes handy in time constrained situations. But the issue with this that they are not suitable for very large offerings and are unavailable to the general public due to which they cannot be traded in the open market. These are more commonly issued by small and more risky borrowers and have mostly may have restrictive conditions attached.

Whereas the publicly traded debts are more secured in comparison to these as they can only be issued after getting registered and acceptance through SEC resulting in an increased cost of issuance and time period. These types of debts are more liquid as they are publicly traded which makes them more information sensitive. As they are offered to the public at large, they can be used to borrow higher amount of money. Information asymmetry is another major factor to determine the choice between the two as managers are more aware of the company’s prospects than the general investors. So if the company is in an adverse position it will prefer issuing public debts to share their losses with new investor and in the opposite case it will refrain from doing so to avoid sharing profits that it will earn in the future(Kale, 2011).

Answer: 3

Determination of Cost of Debt held privately by Institutional Investors

The cost of debt of a firm whose debts are privately owned by institutional investors is based to a huge extend on the level of stability of the institutional investor itself. There is a negative relationship between the two variables. The degree of affect that the stability of institutional investors have on the cost of debt depends upon the cost of agency of the debt, agency cost of equity and how severe the information asymmetry is. The institutional investors are either interested in the monitoring and influencing the managements performance or in short-term trading profits and gathering information. The selection of this depends on the stability of the equity-holdings.Cost Of Capital And Capital Budgeting Case Solution

The cost of debt in such a scenario can be calculated by using the credit ranking of the bond and the credit yield spread. The credit rating can be evaluated using the ranking of agencies like Moody’s and S&P. Variables are assigned to each ranking, the better the ranking the lower the credit variable resulting in a lower cost of debt and vice versa. The credit yield spread can be computed as the difference between the yield to maturity of the company’s coupon-paying bond and the yield to maturity of a treasury bill of the same or closest maturity dates(Elyas( Elyasiani, 2007).........................

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