1403 Words3 Pages

1) The WACC is basically computed by the sum of multiplying the costs per component to its respective proportional weight (how much that company uses a certain cost of capital) [See Appendix 1]. As financial management is focused on the maximization of the stock price, an optimal structure of costs based on these three factors is needed.

In SIVMED’s case, based on the definition of WACC, all capital bases should be included in its WACC. These include its common stock, preferred stock, bonds and long-term borrowings. In addition to being able to compute for the costs of capital, the WACC also determines how much interest SIVMED has to pay for all its activities. The value of the firm’s stock, which we want to maximize, depends of the after-tax cash flow. Hence, after-tax values for WACC are also needed. Furthermore, cost of capital is used to determine the cost of each debt, stock or common equity. Being able to analyze these will be essential into deciding what and how new capital should be acquired. Hence, the present marginal costs are ideally more essential than historical costs.

2)

a. SIVMED’s cost of debt is at 6.6% [See Appendix 2a]

b. Yes, flotations should be part of the calculation of debt cost. This is because Flotation costs are typically included in the component of debt calculation as a part of calculating the nominal rate of the debt’ cost, which cover both underwriting spread and the costs paid by the issuing company.

c. The EAR (6.6%) can deal with debts of different payment frequencies. Nonetheless, nominal rates should be used because the total costs, which are naturally small on public debt issues, decrease the net proceeds from the sale.

d. Coupon rates differ from a 15-year bonds and 30-year bonds because we consider the risk of the bond. Usually, the longer the time for maturity, naturally, the higher the risk, hence, generally, the higher cost of debt. Thus, the estimate is not valid. To make it more valid, though, we need to adjust the yield curve calculated using the 15-year bond to a calculation using a 30-year bond.

e. A way to calculate the cost of debt when the outstanding debt has not been traded is to use a synthetic rating based upon the company’s financial ratios (ie the interest coverage ratio). By getting a default spread based on the ratio and adding the risk-free rate, an updated pre-tax cost of debt estimate is going to surface.

f. It would matter because a callable bond, a bond which can be bought back by the issuer before its maturity, can reduce the cost of debt when the interest rate decreases.

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