• To determine the cost of a new debt in the marketplace:
– The firm will compute the yield on its currently outstanding debt, or yield to maturity
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Approximate Yield to Maturity (Y')
• For ease of reference, = Cost of common equity in the form of retained earnings = Dividend at the end of the first year, $2 = Price of stock today, $40 g = Constant growth rate in dividends, 7% = $2 + 7% = 5% + 7% = 12% $40
– With a low-cost debt, must be chosen carefully
• May result in increase of the overall risk • May make all eventual forms of financing more expensive
20 .6 ($940) + .4 ($1,000) = $101.50 + 60 20 $564 + $400 Y’ = $101.50 + 3 = $104.50 = 10.84% $964 $964
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Adjusting Yield for Tax Considerations
• Yield to maturity indicates how much the firm has to pay on a before-tax basis • Interest payment on a debt is a taxdeductible expense