CP

228 CHAPTER 6 The Cost of Capital

Therefore, if NCC can borrow at an interest rate of 11 percent, and if it has a marginal

federal-plus-state tax rate of 40 percent, then its after-tax cost of debt is 6.6 percent:

Flotation costs are usually fairly small for most debt issues, and so most analysts ignore

them when estimating the cost of debt. Later in the chapter we show how to incorpo-

rate flotation costs for those cases in which they are significant.

Why is the after-tax cost of debt rather than the before-tax cost used to calcu-

late the weighted average cost of capital?

Is the relevant cost of debt the interest rate on already outstandingdebt or that

on newdebt? Why?

Cost of Preferred Stock, rps

A number of firms, including NCC, use preferred stock as part of their perma-

nent financing mix. Preferred dividends are not tax deductible. Therefore, the

company bears their full cost, andno tax adjustment is used when calculating the cost

of preferred stock.Note too that while some preferreds are issued without a stated

maturity date, today most have a sinking fund that effectively limits their life. Fi-

nally, although it is not mandatory that preferred dividends be paid, firms generally

have every intention of doing so, because otherwise (1) they cannot pay dividends

on their common stock, (2) they will find it difficult to raise additional funds in the

capital markets, and (3) in some cases preferred stockholders can take control of the

firm.

The component cost of preferred stock used to calculate the weighted average

cost of capital, rps, is the preferred dividend, Dps, divided by the net issuing price, Pn,

which is the price the firm receives after deducting flotation costs:

(6-2)

Flotation costs are higher for preferred stock than for debt, hence they are incorpo-

rated into the formula for preferred stocks’ costs.

To illustrate the calculation, assume that NCC has preferred stock that pays a $10

dividend per share and sells for $100 per share. If NCC issued new shares of preferred,

it would incur an underwriting (or flotation) cost of 2.5 percent, or $2.50 per share,

so it would net $97.50 per share. Therefore, NCC’s cost of preferred stock is 10.3

percent:

Does the component cost of preferred stock include or exclude flotation costs?

Explain.

Why is no tax adjustment made to the cost of preferred stock?

rps$10/$97.5010.3%.

Component cost of preferred stockrps

Dps

Pn

.

6.6%.

11%(0.6)

rd(1
T)11%(1.0
0.4)

The Cost of Capital 225