Cost of capital (Part I) – Theory and concepts

March 29, 2014

In this two-part article series, we will discuss how to calculate a firm’s cost of capital. This is an important measurement with several business applications. We’ll go over the basic concepts below - the second part will focus on the practical applications.

1. Cost of debt financing

For the second part of this article series, refer to Cost of capital (Part II) – Practical applications.

The cost of debt can be deceptive on first glance. If XY Corporation (i.e., fictitious entity) issues $10,000,000 in bonds that carry a 9% interest rate, it might seem that XY’s cost of debt is simply 9%. That, however, is not the case. Debt is a unique form of financing - it is the only type that offers a tax advantage. Because a company is allowed to deduct interest expense when calculating taxable income, we need to take into account marginal tax rates. The formula to use when determining the cost of debt is as follows:

Cost of Debt Financing = i x (1-t)

 where i is the debt’s yield to maturity and t is the company’s marginal tax rate.

Note that yield to maturity takes into account costs associated with issuing debt (such as legal fees), so it will be slightly different than the coupon rate for the debt instrument. The calculation of yield to maturity is beyond the scope of this article.

Continuing the example of XY Corporation, let’s assume the bond’s yield to maturity is 9% and that the marginal tax rate in effect is 40%. The cost of the debt to XY would therefore be:

Cost of Debt Financing = 9% x (1 - 40%) = 5.4%

We’ll discuss what this percentage means in the second part of the article series.

2. Cost of preferred equity capital

As we talk about in this article on preferred stock, preferred stock is something of a hybrid between debt and equity, depending on the terms of the securities. It is a form of corporate ownership like common stock, but it carries a specifically-stated dividend rate like interest rate of debt instruments. Unlike the interest associated with debt financing, dividends paid on preferred and common stock are not deductible for tax purposes, so the cost of preferred equity cannot be reduced by the marginal tax rate.

To find a corporation’s cost of preferred equity, divide the stated dividend payout by the amount of money received for the stock issuance (regardless of whether the dividend is actually paid):

Cost of Preferred Equity Capital = Dividend Payout ÷ Proceeds from Stock Issuance

For example, let’s say that XY Corporation issues $500,000 of 7% preferred stock (which is a payout of $35,000 annually) and receives $512,000 from the stock issuance. XY’s cost of preferred equity would be:

Cost of Preferred Equity Capital = $35,000 ÷ $512,000 = 6.8%

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