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Estimating the Cost of Debt Capital Kellogg Company manufactures cereal and other convenience food under its...

Estimating the Cost of Debt Capital

Kellogg Company manufactures cereal and other convenience food under its many well-known brands such as Kellogg’s®, Keebler®, and Cheez-It®. The company, with over $13.5 billion in annual sales worldwide, partially finances its operation through the issuance of debt. At the beginning of its 2015 fiscal year, it had $6.7 billion in total debt. At the end of fiscal year 2015, its total debt had increased to $6.8 billion. Its fiscal 2015 interest expense was $418 million, and its assumed statutory tax rate was 37%.

a. Compute the company’s average pretax borrowing cost. (Hint: Use the average amount of debt as the denominator in the computation.)

Round your answer to one decimal place (ex: 0.0345 = 3.5%).

b. Assume that the book value of its debt equals its market value. Then, estimate the company’s cost of debt capital.

Round your answer to one decimal place (ex: 0.0345 = 3.5%).

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Answer #1

Debt is used to represent any security which bears a fixed financial charge. The cost of debt refers to the cost associated with using fixed interest bearing securities

To calculate pre-tax cost of debt, take the sum total of debt-related interest payments divided by the total amount of debt taken on for the year.

Annual sales - $13.5 billion

Total outstanding Debt - $6.8 billion

Interest expenses- $418 million

A) Average Pre tax borrowing cost -To calculate pre-tax cost of debt, take the sum total of debt-related interest payments divided by the total amount of debt taken on for the year.

=Total interest payments/ Average outstanding debt

= $418 million/ $6.75 billion

= 0.0619 or 6.19 %

Average outstanding debt = ($6.7+ $6.8)/2 =$ 6.75 billion

B) Cost of debt capital - it must be noted that the interest payable on debt capital is tax deductible expense. Therefore company calculates cost of debt after tax which is termed as ‘ post tax cost of debt’

After tax cost of debt = Pretax cost of debt * (1- tax rate)

= 6.19 *(1-0.37) = 3.89%

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