that firms can carry losses forward and can offset them
againstprofitsinfutureperiods.Themostprudentassessment
ofthetaxeffectsof debtwillthereforeprovidefor notax
advantages in theyears of operatinglosses and willbegin
adjustingfortaxbenefitsonlyinfutureyearswhenthefirmis
expected to have operating profits.
ILLUSTRATION 2.5: Estimating Costs of Debt: Some
Examples
Earlierin the chapter, weestimated thecost of equity for
Disney in early 2004, and Embraer and Kristin Kandy in
2005.Inthissection,weconsiderhowbest toestimatethe
cost of debt for each of these firms:
- Inearly2004,Disneyhadbondsoutstandingandwas
ratedby S&Pand Moody’s. TheS&Pbond rating
wasBBB+ and thedefault spread forBBB+ rated
bondswas1.25%.Addingthisdefaultspreadonto
thethenprevailingTreasurybondrateof4%yielded
apretaxcostofdebtof5.25%.Usingthemarginal
taxrateof37.3%resultsinanafter-taxcostofdebtof
3.29%. - ForKristinKandy,weusedTable2.4toestimatea
synthetic rating.Thefirmhad operating income of
$500,000andinterestexpensesof$85,000,resulting
in aninterest coverageratio of5.88.Thesynthetic
rating that weestimate for thefirm isA- and the