Want to determine cost of debt for WACC for Microsoft. Took the YTM of a 10 yr. bond and multiplied it with (1-.35). Is this correct or do I have to take the effective Tax Rate?? TNX!

Question

anonymous · Answer

Using 35% is an approximation, if you have the actual effective tax rate I would rather use it. You should be able to find it on the latest annual report. In any case to calculate the cost of debt for any company you would have to adjust the risk free rate (10yr government bond or any other proxy) to the company´s beta, otherwise you wouldn´t be accounting for the extra return required due to an investment in a non-risk free corporate. Of course, a much more precise way to calculate the actual cost of debt for an existing company would be to look into the annual report and calculate the weighted average of all the debt instruments financing that particular company.

anonymous · Answer

MSFT is AAA, so I suppose using a 10 yr risk free US govt treasury as the cost of debt will work.  Then you need to find the after tax cost of debt.  The tax rate used is the marginal tax rate, not the effective tax rate.  There is a tax savings because interest is tax deductable.  That savings happens on the last dollar made by the company, which will be taxed at the marginal rate (40% is a good estimate).