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Q: Financial Anyalsis II ( Answered ,   5 Comments )
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 Subject: Financial Anyalsis II Category: Miscellaneous Asked by: noah0304-ga List Price: \$15.00 Posted: 10 Jun 2005 16:36 PDT Expires: 10 Jul 2005 16:36 PDT Question ID: 532023
 ```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?``` 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?```
 Subject: Re: Financial Anyalsis II Answered By: omnivorous-ga on 11 Jun 2005 21:38 PDT Rated:
 ```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```
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 Subject: Re: Financial Anyalsis II From: myoarin-ga on 10 Jun 2005 19:35 PDT
 `Did he? What is the relationship between dividend payments and cost of debt?`
 Subject: Re: Financial Anyalsis II From: omnivorous-ga on 10 Jun 2005 21:10 PDT
 `Taxes.`
 Subject: Re: Financial Anyalsis II From: noah0304-ga on 11 Jun 2005 09:12 PDT
 `I'm not sure what you are asking? Please clarify your question. Thanks`
 Subject: Re: Financial Anyalsis II From: myoarin-ga on 11 Jun 2005 16:56 PDT
 ```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.```
 Subject: Re: Financial Anyalsis II From: omnivorous-ga on 11 Jun 2005 21:48 PDT
 ```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```