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 firms cash flow. In addition, increasing the debt level may cause a reduced rating of the companys bonds. The marginal tax rate is 40%. All the numbers are expressed in todays dollars. The forecasted average inflation per year is 3.5%.

Cost of debt:

The companys bond rating is roughly at the high end of the A range. Surveying the debt market yielded the following information about the cost of debt for different rating levels:

Bond rating	AA	A	BBB
Interest cost range	5.5% ~ 6.5%	6.25% ~ 7.5%	7.5% ~ 9%

The companys current bonds have a yield to maturity of about 6.5%.

What is the Costs of Debt?