Cost Of Debt

Cost of debt

When individuals use the cost of debt, they should know the measurement of the interest rate, or the yield paid to the bondholders. When analyzing the cost of debt, people should know that it's an effective rate that businesses are willing to pay on the current debt that they have accrued. The cost of debt is a measurement of the before or after tax returns. Considering the case that individuals can deduct the interest, makes the tax after cost more popular than the before tax. A business will typically use different bonds, loans, and different techniques for debt. This is a measure that individuals pay to a business to use the debt financing. This means of measurement is a good opportunity for investors to get an idea of how risky the business endeavors are when compared to other companies. This is because a riskier business will typically have an increased cost of their debt. "In order to obtain the after tax rate, you must multiply the before tax rate by one minus the marginal rate (before tax rate X (1-marginal tax)). However, if a business has debt and it is in the form of a single bond, and it is paid at 5% than the before tax cost of debt would only be 5%. But if a businesses marginal tax rate is 40%, than the businesses after tax cost of debt would be 3% (5% x (1-40%)) (Answers, 2007, p.1)."

Cost of preferred stock

The fact that the cost of debt and the preferred stock both require consistent annual payments make them both quite similar. However, they differ in the case that there is not a maturity date in which a principal payment is paid. When calculating the cost of a preferred stock the tax adjustments are not used. The reasoning for this is because, interest must be paid on debt, "but the dividend payments on the preferred stocks are not tax deductible (Kennon, 2007, p.1)."

Cost of common equity

Common equity comes from the retained earnings, but can also come from the issuing of the new common stocks. Individuals should realize that a cost of common equity in a form of retained earnings is equal to a required rate of return. This is compatible to a firm's common stock. Individuals also look at as the opportunity cost.

* When using the valuation approach in determining the cost of the common stock, it is very important to have poise when dealing the pricing and the demands of the current and future stockholders. Individuals should develop some type of model to value the common stock. Moreover, from this model make up a formula for the required return on common stock (Glock, 2005, p.317).

* Individuals use the capital asset pricing model to describe the relationship between a company's risk and expected return. That is than used