Complete Guide To Corporate Finance

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Cost Of Capital - Cost Of Debt And Preferred Stock

Recall from Section 5 that companies sometimes finance their operations through debt in the form of bonds because bonds provide more flexible borrowing terms than banks. How much do companies pay for this debt?

Compared to cost of equity, cost of debt is fairly straightforward to calculate. The rate applied to determine the cost of debt (Rd) should be the current market rate the company is paying on its debt. If the company is not paying market rates, an appropriate market rate payable by the company should be estimated.

Calculating the Cost of Debt
Because companies benefit from the tax deductions available on interest paid, the net cost of the debt is actually the interest paid less the tax savings resulting from the tax-deductible interest payment.

The after-tax cost of debt can be calculated as follows:



After-tax cost of debt = Rd (1-tc)
Note: Rd represents the cost to issue new debt, not the cost of the firm\'s existing debt.


Example: Cost of Debt
Newco plans to issue debt at a 7% interest rate. Newco's total (both federal and state) tax rate is 40%. What is Newco's cost of debt?

Answer:

Rd (1-tc) = 7% (1-0.40) = 4.2%

Calculating the Cost of Preferred Stock
As we discussed in section 6 of this walkthrough, preferred stocks straddle the line between stocks and bonds. Technically, they are equity securities, but they share many characteristics with debt instruments. Preferreds are issued with a fixed par value and pay dividends based on a percentage of that par at a fixed rate.

Cost of preferred stock (Rps) can be calculated as follows:


Rps = Dps/Pnet
where:
Dps = preferred dividends
Pnet = net issuing price

Example: Cost of Preferred Stock
Assume Newco's preferred stock pays a dividend of $2 per share and sells for $100 per share. If the cost to Newco to issue new shares is 4%, what is Newco's cost of preferred stock?

Answer:
Rps = Dps/Pnet = $2/$100(1-0.04) = 2.1%

For more on this subject, read Prefer Dividends? Why Not Look At Preferred Stock?

Next, we'll take a look at the weighted average cost of capital, a calculation that will put our formulas for both the cost of equity and the cost of debt to work.

Weighted Average Cost Of Capital (WACC)


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