The following assumptions are used to determine the cost of capital.
Historically, the company tried to maintain a debt to equity ratio equal to 0.40. This ratio was used, because lowering the debt implies giving up the debt tax shield, and increasing it makes debt service a burden on the firm's cash flow. In addition, increasing the debt level may cause a reduced rating of the company's bonds. The marginal tax rate is 35%.
Cost of debt:
The company's bond rating is roughly AAA. Surveying the debt market yielded the following information about the cost of debt for different rating levels:
The company's current bonds have a yield to maturity of about 4.25%.
Cost of equity:
The current 10-year Treasury notes have a yield to maturity of 2.25% and the forecast for the S&P 500 market premium is 7.5%. The company's overall b is 1.25.