Corporate financeLesson 2 of 4 in the course How Firms Raise Capital

Estimating the Cost of Debt and Equity Capital

5 flashcards · 5 quiz questions · 5 match pairs · 5 fill-in sentences · English

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Summary

A firm’s cost of debt reflects the return lenders currently require in exchange for lending to the firm. This lesson explains why current market conditions—not the original coupon rate—determine the before-tax cost of debt, and how the interest tax deduction reduces the firm’s effective cost.

A company’s cost of debt is the interest rate it would have to pay to borrow or refinance at current market conditions. The prices of existing bonds change as interest rates, the credit environment, and the firm’s ability to repay change. For that reason, use current market values and required returns rather than relying on historical borrowing terms.

All flashcards

What is a firm’s cost of debt?
The interest rate the firm would currently have to pay to borrow or refinance, based on market conditions.
What does yield to maturity (YTM) measure?
The return a purchaser expects from buying a bond at its current price, holding it to maturity, and receiving its promised payments.
How is after-tax cost of debt calculated?
Multiply the before-tax cost of debt by one minus the firm’s tax rate: rd(1−T)r_d(1-T).
Why must a firm estimate its cost of equity?
Shareholders have no fixed contractual interest payment, so their required return is not directly stated.
What does equity beta measure in CAPM?
A stock’s systematic risk relative to the market.

Quiz questions

  1. A bond trades below its face value. Compared with its coupon rate, what is its YTM generally?Answer: Higher, because the investor also gains from receiving face value at maturity.
  2. A firm’s before-tax cost of debt is 8% and its tax rate is 25%. What is its after-tax cost of debt?Answer: 6%
  3. Using CAPM, what is the cost of equity when the risk-free rate is 3%, the expected market return is 11%, and beta is 1.3?Answer: 13.4%
  4. A company paid a $1.50 dividend last year. If dividends are expected to grow by 2% and the share price is $12.50, what cost of equity does the constant dividend growth model estimate?Answer: 14.24%
  5. Which inputs does CAPM use to estimate a firm’s cost of equity?Answer: The risk-free rate, equity beta, and market risk premium.

Based on Principles of Finance by Julie Dahlquist, Rainford Knight (OpenStax), licensed CC BY 4.0. Adapted into a summary, flashcards and quizzes.

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