Principles of Finance

# 17.2The Costs of Debt and Equity Capital

Principles of Finance17.2 The Costs of Debt and Equity Capital

By the end of this section, you will be able to:

• Calculate the after-tax cost of debt capital.
• Explain why the return to debt holders is not the same as the cost to the firm.
• Calculate the cost of equity capital.

The costs of debt and equity capital are what company lenders (those who allow the firm to use their capital) expect in return for providing that capital. Just as current market values of debt and equity should be used in determining their weights in the capital structure, current market values of debt and equity should be used in determining the costs of those types of financing.

## Cost of Debt Capital

A company’s cost of debt is the interest rate it would have to pay to refinance its existing debt. Because a firm’s existing debt trades in the marketplace, its price changes according to market conditions. The overall credit environment can change due to changing macroeconomic conditions, causing a change in the price of debt securities. In addition, as there are changes in the overall riskiness of the firm and its ability to repay its creditors, the price of the debt securities issued by the firm will change.

The market price of a company’s existing bonds implies a yield to maturity. Recall that the yield to maturity is the return that current purchasers of the debt will earn if they hold the bond to maturity and receive all of the payments promised by the borrowing firm.

### Yield to Maturity and the Cost of Debt

Bluebonnet’s debt is selling for 97% of its face value. This means that for every $100 of face value, investors are currently paying$97 for an outstanding bond issued by Bluebonnet Industries. This debt has a coupon rate of 6%, paid semiannually, and the bonds mature in 15 years.

### Footnotes

• 1The specific financial calculator in these examples is the Texas Instruments BA II PlusTM Professional model, but you can use other financial calculators for these types of calculations.
Order a print copy

As an Amazon Associate we earn from qualifying purchases.