Component Cost of Capital

Each source of capital has a different cost because of the differences among the sources, such as seniority, contractual commitments, and potential value as a tax shield. For business, there are mainly three sources of capital: debt, preferred equity, and common equity. Understanding the cost of each part is crucial in knowing the cost of capital of business.

Cost of Debt

The cost of debt is the cost of debt financing to a company when it issues a bond or takes out a bank loan. There are two methods to estimate the before-tax cost of debt: the yield-to-maturity approach and debt-rating approach.

The YTM approach: The yield to maturity (YTM) is the annual return that an investor earns on a bond if the investor purchases the bond today and holds it until maturity. In other words, it is the yield that equates the present value of the bond's promised payments to its market price.

The debt rating approach: when a reliable current market price for a company's debt is not available, the debt-rating approach can be used to estimate the before-tax cost of debt. Based on a company's debt rating, we estimate the before-tax cost of debt by using the yield on comparably rated bonds for maturities that closely match that of the company's existing debt.

A consideration when using this approach is that debt ratings are ratings of the debt issue itself, with the issuer being only one of the considerations. Other factors, such as debt seniority and security, also affect ratings and yields, so care must be taken to consider the likely type of debt to be issued by the company in determining the comparable debt rating and yield. The debt-rating approach is a simple example of pricing on the basis of valuation-relevant characteristics, which in bond markets has been. known as evaluated pricing or matrix pricing.

However, The estimate of debt cost has many challenges in practice considering the types and varieties of the debt.

Fixed debt or Floating debt: Up to now, we have assumed that the interest on debt is a fixed amount each period. We can observe market yields of the company's existing debt or market yields of debt of similar risk in estimating the before-tax cost of debt. However, the company may also issue floating rate debt in which the interest rate adjusts periodically according to a prescribed index, such as the prime rate or LIBOR, over the life of the instrument. Estimating the cost of a floating-rate security is difficult because the cost of this form of capital over the long term depends not only on the current yields but also on the future yields. The analyst may use the current term structure of interest rates and term structure theory to assign an average cost to such instruments.

Debt with options: How should an analyst determine the cost of debt when the company used debt with option like features, such as call, conversion, or put,provisions? Clearly, options affect the value of debt. For example, a callable bond would have a yield greater than a similar noncallable bond of the same issuer because bondholders want to be compensated for the call risk associated with the bond. In a similar manner, the put feature of a bond, which provides the investor with an option to sell the bond back to the issuer at a predetermined price, has the effect of lowering the yield on a bond below that of a similar nonpntable bond. Analyst needs to consider the options value in determining the cost of debt.

Cost of preferred Stock

The cost of preferred stock is the cost that a company has committed to pay preferred stockholders as a preferred dividend when it issues preferred stock. In the case of nonconvertible, noncallable preferred stock that has a fixed dividend rate and no maturity date (fixed rate perpetual preferred stock), we can use the formula for the value of a preferred stock:

V= Dp / RP

The cost of preferred stock is the preferred stock's dividend per share divided by the current preferred stock's price per share. Unlike interest on debt, the dividend on preferred stock is not tax-deductible by the company; therefore, there is no adjustment to the cost for taxes

Cost of Common Equity

The cost of common equity is  the rate of return required by a company's common shareholders. A company may increase common equity through the reinvestment of earnings-that is, retained earnings-or through the issuance of new shares of stock.

The estimation of the cost of equity is challenging because of the uncertain nature of the future cash flows in terms of the amount and timing. Commonly used approaches for estimating the cost of equity include the capital asset pricing model, the dividend discount model, and the bond yield plus risk premium method.