Cost Of Debt Case Study

Table of Contents

1.0 OVERVIEW OF COST OF CAPITAL 2

2.0 COST OF LONG-TERM DEBT 3

2.1 How to Calculate Before Tax Cost of Debt and After-tax cost of debt. 4

3.0 COMMON STOCK 6

4.0 COST OF PREFERRED STOCK 8

4.1 Characteristic of preferred stock 8

5.0 WEIGHTED AVERAGE COST OF CAPITAL 11

6.0 CONCLUSION 14

1.0 OVERVIEW OF COST OF CAPITAL

Cost of capital is the rate of return when a firm earn on the projects invest to maintain the market value of its stock. The cost of capital depends on the how the financial used. Its means they used cost of equity which is business is finance through equity or cost of debt which is finance through debt. Many companies used these two combinations to finance their business. Their overall cost

Before-Tax Cost of Debt

The way to calculate before-tax cost of debt is first, we have to divide the company’s effective rate to convert to decimal places by 100. For example, the company pays 10 percent (10%) in tax, so divide the amount to 0.10. Second, we need to subtract the tax rate expressed as a decimal from 1.00. For example, subtract 0.10 from 1.00 to get 0.90. And last, using the result of 0.90 and divide by the company’s after-tax cost of debt to calculate company’s before-tax cost of debt. In this example, if the company's after tax cost of debt equals $830,000, divide $830,000 by 0.90 to find a before-tax cost of debt of $922,222.22.

In this world, there’s several of method to calculate the cost of debt. One of them is focus on the yield to maturity (YTM), since YTM is very needed in the market of demand. The function of YTM is company or organization can measure debt of an appropriate maturity with assume the YTM on this debt will be company cost.

Equation: Before-Tax Cost of Debt

Component Cost of Debt =

Its was a quite difficult to estimate the cost related to issuing the common stock. This is because the nature of the cash flow streams to common shareholders. As a result, they receive their return in the term of dividend and the dividend they received is not fixed as a dividend is at the discretion of the board of director.

There are two methods or techniques to estimate the cost of common stock; the dividend valuation model and the capital asset pricing model.

1. Using the dividend valuation model:

The dividend valuation model tells that the stock price of share is the present value of all its future cash dividends (assume to grow at a constatnt rate) that is expected to provide over an infinite time horozon. P0= D1 rs – g

Where D1 is next period’s dividends, g is the growth rate of dividend per year, and P is the current stock pice per share. The expression for the cost of common stock equity: rs = _D1_ + g