115 CFA
File: Corporate Finance - Reading 33 - 2. Cost of Debt and Preferred Stock

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

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