Session 2: Cost of Debt and Equity Capital

Learning Outcome
At the end of the session, Learners should be able to understand how to determine the cost for debt and equity sources of funds.

Important Learning Terms

• Cost of Debt capital
• Cost if Equity Capital
• Yield to maturity
• Capital Assets Pricing Model

A. Cost of Debt Capital
The cost of debt capital is what the firm must pay (stated as a percent per year) to the purchasers of its (new) bonds..

Cost of bank borrowings
Bank borrowings do not have a market price with which to relate interest and payments to in order to calculate their cost as is the case with securitized debt. Thus, to approximate the cost of bank borrowings the interest rate paid on the loan should be taken, making the appropriate calculation to allow for the tax deductibility of the interest payments.

B. The Cost of Preferred Stock

C. The Cost of Common Equity Capital
The cost of equity capital is equal to the required rate of return on equity-supplied capital. There are two categories of equity costs:

The cost of retained earnings, ks, is estimated with two models:

Where F = the dollar amount of flotation costs per share.

Example: The Simu Tel Corporation's next expected dividend = $2.00 per share. The growth rate of dividends = 5% and is expected to remain constant. The current market price per share = $40 and flotation costs per share = $2.00.

The cost of issuing new equity common stock is:

10.26% = $2.00/($40-$2) + .05

The firm's net proceeds per share = $38 = ($40 - $2)

Note: The presence of flotation costs raise the cost of new equity capital

New common stock is issued when:

1. the firm needs capital and/or
2. when the firm's capital structure debt/equity mix needs re-alignment