Debt and Equity Instruments
Understanding the different debt and equity instruments gives managers the ability to make more accurate decisions that will help develop greater business prospects and opportunities. The cost of capital is what companies use to decide how they can increase money through borrowing or investing in stock. It is the required return that is crucial in making a budgeting project worth doing. Both the cost of debt and the cost of equity are what comprise the cost of capital. Costs are related to preferred stocks, common stocks and financial capital. These all play an important factor and can decide the success or failure of the company. These costs supply stockholders and financial management with the appropriate tools to help calculate investments and find what the percentage of the cost will be and if it will benefit them or not. Cost of capital uses the following variables: Kd which represents debt, Kp which represents preferred stock, Ke which represents common equity and Ka which is the weighted average cost of capital.
Cost of Debt
The cost of debt is defined as “the effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns” (Investopedia, 2009). The formula for calculating the cost of debt is as follows:
Kd(Cost of debt) = Y(Yield) (1-T)
Cost of debt is a cost (after tax) that can be measured by simply taking the yield and multiplying that number by 1 minus the tax rate. The investors have the ability to assume that if the actual cost of this new debt is advantageous or not. The investor can now look at the cost of debt to see if it is lower than the given yield of maturity. If the cost of debt is in fact lower, then the investor should anticipate a larger return.
Cost of Preferred Stock
Cost of preferred stock is calculated by the following formula: The cost of preferred stock (Kps) is equal to the dividend (Dps) divided by the net issuing price (Pp)...