Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VI. Cost of Capital and

Long−Term Financial

Policy

15. Cost of Capital © The McGraw−Hill^527
    Companies, 2002

THE COSTS OF DEBT AND

PREFERRED STOCK

In addition to ordinary equity, firms use debt and, to a lesser extent, preferred stock to
finance their investments. As we discuss next, determining the costs of capital associ-
ated with these sources of financing is much easier than determining the cost of equity.

The Cost of Debt

The cost of debtis the return that the firm’s creditors demand on new borrowing. In
principle, we could determine the beta for the firm’s debt and then use the SML to esti-
mate the required return on debt just as we estimated the required return on equity. This
isn’t really necessary, however.
Unlike a firm’s cost of equity, its cost of debt can normally be observed either di-
rectly or indirectly, because the cost of debt is simply the interest rate the firm must pay
on new borrowing, and we can observe interest rates in the financial markets. For ex-
ample, if the firm already has bonds outstanding, then the yield to maturity on those
bonds is the market-required rate on the firm’s debt.
Alternatively, if we know that the firm’s bonds are rated, say, AA, then we can sim-
ply find out what the interest rate on newly issued AA-rated bonds is. Either way, there
is no need to estimate a beta for the debt because we can directly observe the rate we
want to know.
There is one thing to be careful about, though. The coupon rate on the firm’s out-
standing debt is irrelevant here. That rate just tells us roughly what the firm’s cost of
debt was back when the bonds were issued, not what the cost of debt is today.^5 This is
why we have to look at the yield on the debt in today’s marketplace. For the sake of con-
sistency with our other notation, we will use the symbol RDfor the cost of debt.

CONCEPT QUESTIONS

15.2a What do we mean when we say that a corporation’s cost of equity capital is 16

percent?

15.2bWhat are two approaches to estimating the cost of equity capital?

CHAPTER 15 Cost of Capital 499

This suggests that 15.6 percent is Alpha’s cost of equity. We next use the dividend growth

model. The projected dividend is D 0 (1 g) $2 1.08 $2.16, so the expected return

using this approach is:

RED 1 /P 0 g

$2.16/30 .08

15.2%

Our two estimates are reasonably close, so we might just average them to find that Alpha’s

cost of equity is approximately 15.4 percent.

15.3

cost of debt

The return that lenders

require on the firm’s debt.

(^5) The firm’s cost of debt based on its historic borrowing is sometimes called the embedded debt cost.