# 2. Cost of Debt and Preferred Stock

## f. calculate and interpret the cost of debt capital using the yield-to-maturity approach and the debt-rating approach;

## g. calculate and interpret the cost of noncallable, nonconvertible preferred stock;

What is the cost of debt?

The cost of debt is defined as the cost to the firm in terms of the interest rate that it pays for ordinary debt (`r_d`

) less the tax savings that are achieved. Interest on debt is tax-deductible and therefore to calculate the cost of debt the tax benefit is deducted.

What is the formula for Yield-to-Maturity approach for determining before-tax cost of debt?

$$P_0 = \frac{PMT_1}{1 + \frac{r_d}{2}} + ... + \frac{PMT_n}{(1 + \frac{r_d}{2})^n} + \frac{FV}{(1 + \frac{r_d}{2})^n}$$

What is the Debt Rating approach to determining the before-tax cost of debt?

Based on the company's debt rating, the before-tax cost of debt is estimated by using the yield on comparably rated bonds for maturities that are a close match to those of the firm's existing debt.

What are four common issues when estimating the cost of debt?

- Fixed-rate debt versus floating-rate debt

- Debt with option-like features

- Non-rated debt

- Leases

What is Cost of Preferred Stock and what is the formula?

- The cost of preferred stock is calculated by dividing the dollar amount of the dividend (which is normally paid on an annual basis) by the preferred stock current price.

- $$r_P = \frac{D_P}{P_P}$$

##### Source:

- CFA