Cost of Capital. A financial analyst at Dawn Chemical notes that the
firm?s total interest payments this year were $10 million while total
debt outstanding was $80 million, and he concludes that the cost of
debt was 12.5 percent. What is wrong with this conclusion?

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Clarification of Question by noah0304-ga on 11 Jun 2005 17:41 PDT

A financial analyst at Dow Chemical notes that the
firm?s total interest payments this year were $10 million while total
debt outstanding was $80 million, and he concludes that the cost of
debt was 12.5 percent. What is wrong with this conclusion?

This company was suppose to be Dow not Dawn.  Sorry.  Can you help
with this question?

Noah0304 --

The answer was actually in my comment: "taxes."  A profitable firm
actually benefits from the tax-deductibility of interest. Dow Chemical
would not be paying taxes on interest paid, reducing its tax bill.

In other words, if Dow pays 30% in taxes, the after-tax cost of the
bond is only $7M -- and that's only 8.75%.

WEIGHTED-AVERAGE COST OF CAPITAL
=================================

The full weighted-average cost-of-capital (WACC) for a firm is given by:

WACC = rE (E/VL) + rD(1-t)(D/VL)

where,
rE: return on equity
E/VL: proportion of equity in total firm value
rD: bond returns (which are slightly different for the two divisions)
t: tax rate (expressed as a decimal; 40% = 0.40)
D/VL: proportion of debt in total firm value

We'll ignore the rE portion of the WACC to concentrate on the debt
portion and you'll see that it figures the same thing --
The firm's RD = rD(1-t) -- 12.5%*(1-0.30) = 8.75%


OTHER ISSUES
=============

There is also at least one other potential financial issue: the
possibility that the bonds have a beta or firm-oriented risk different
from 1 -- though this seems to be outside the scope of your question.

Higgins article linked below explains that debt may carry a risk
factor that changes the cost-of-debt.  Make sure that you see the
"Cost of Capital" section here:
QuickMBA
"Analysis for Financial Management," Robert Higgens
"Corporate Finance -- Cost of Capital"
http://www.quickmba.com/finance/cf/

Google search strategy:
WACC + "after-tax"
beta + bonds + "corporate finance"

Best regards,

Omnivorous-GA

Did he?  What is the relationship between dividend payments and cost of debt?

Taxes.

I'm not sure what you are asking?  Please clarify your question.  Thanks

Although I have seen now that there actually is a Dawn Chemical
company, the question appears to be a homework assignment, especially
as one cannot imagine a financial analyst relating outstanding debt at
one point in time with interest paid over twelve months.
Maybe I misread the question last night when I thought it said
"dividend payments".  Sorry, if that was the case.*  Since I thought
it was, it would have made the analyst's remark even stranger. That is
why I commented so facetiously.
My apologies.  I wanted to reply hours ago, but dear google wouldn't let me.
Myoarin
*I rather expect that omniverous-ga would have caught me on that error.

Myoarin --

Though preferred dividends have long been considered "dividends" and
not debt payments, some financial analysts put them in the same
category when looking at "free cash flow," so I wouldn't consider your
comment to be off-the-wall.

FASB rules have been changed so regularly about categories --
capitalizing some leases; recently moving co-operative marketing costs
from expenses to a reduction in revenues -- that I actually checked
the Merrill Lynch-Addison guide "Understanding Financial Reports" even
before posting this comment:

Merrill Lynch
?Understanding Financial Reports,? (2003)
http://philanthropy.ml.com/ipo/resources/pdf/understandingfinancial.pdf

Another good reference is this guide, though the former guide seems
more in-step with recent FASB rulings:
Merrill Lynch
?How to Read a Financial Report? (undated)
http://philanthropy.ml.com/ipo/resources/pdf/howtoreadfinreport.pdf

Best regards,

Omnivorous-GA