Engineering Economic Analysis

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Cost of Funds 475

COST OF FUNDS

'Cost of Borrowed Money

A first step in deciding on a minimum attractive rate of return might be to determine the

interest rate at which money can be borrowed. Longer-term secured loans may be obtained

from banks, insurance companies, or the variety of places in which substantial amounts of

money accumulates (for example, the oil-producing nations).

A large, profitable corporation might be able to borrow money at the prime rate, that

is, the interest rate that banks charge their best and most sought-after customers. All other

firms are charged an interest rate that is higher by one-half to several percentage points.

In addition to the financial strength of the borrower and his ability to repay the loan, the

interest rate will vary depending on the duration of the loan.

Cost of Capital

Another relevant interest rate is the cost of capital. The general assumption concerning

the cost of capital is that all the money the firm uses for investmentsis drawn from all the

components of the overall capitalization of the firm. The mechanics of the computation is

given in Example 15-1.

For a particular firm, the purchasers of common stock require an 11% rate of return, mortgage

bonds are sold at a 7% interest rate, and bank loans are available at 9%. Compute the cost of

capital for the following capital structure:.

$ 20 million

20

60

Bank loan

Mortgage bonds

Common stock and

retained earnings

Rate of

Return

9%

7

11

Annual

Amount

$1.8 million

1.4

6.6

$100 million $9.8 million

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SOLUTIONr

Interest payments on debt, like bank loans and mortgage bonds, are tax deductible business

.expenses. Thus:

After-tax interest cost=(Before-tax interest cost) x (1 - Tax rate)

If,weass4me thaMl).e..firm,pays40% income::taxes,,;thecomputat:j.onSbecome: ': .: - --

Bank loan After-tax interest cost .9%(1- 0.40)~ 5.4%
MOJ:tgageponds AfteJi:-taxinteJ;est cost ~~ 7~(1- 0.40) .. 4.2%

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