Question

1) The Cost of Capital (also known as the Weighted Average Cost of Capital or WACC) is the average cost of all of the different kinds of capital that the company is using. The company could be utilizing various forms of debt, preferred stock, and/or common stock. When looking at cost of debt we measure it by the cost of raising new funds. If we were talking about bonds, we would look at the cost of issuing new bonds. If we were talking about bank loans, we would look at the cost of getting a loan at a bank. Why wouldn't we just use the cost of the current bonds or loans?

Answer 1

Cost of current bonds and loan is not used when computing the cost of capital or WACC for the simple reason that cost of raising new funds indicates the current cost of debt that a company will incur. Using the cost of the current bonds or loans presents a false picture as it is a historical cost and because of changes in inflation rate, state of the economy etc. the historical cost does not reflect the prevailing cost of debt.

It should be noted that in WACC we use market value of debt and since this is not the historical value of debt we should also not be using historical cost of debt with it. Also other charges and fees like legal fees, underwriting fees, registration fees etc. are also accounted for when we consider the cost of raising new funds.