Question

Estimate both the cost of debt and the cost of equity. Explain how to estimate the Corporate Cost of Capital and provide the formula used for CCC.

Answer 1

Answer: Cost of debt- It is the total amount of interest that a company pays on loan for a particular accounting period. It can be calculated in following ways:

• Cost of debt formula= Interest expense * (1- Tax rate)
• Cost of debt can also be calculated by calculating Yield to maturity on bonds, i.e. YTM * (1-Tax rate).
• It can also be calculated by taking Effective interest rate into account. Annual interest / Debt obligation *100. Cost of debt = Effective interest rate * (1- Tax rate)

Cost of Equity- It is the return that shareholders expect by investing their money in the company in the form of shares. It can be calculated in following ways:

• Cost of equity can be calculated through CAPM- Re = Rf + Beta (Rm-Rf); where Rf is risk free rate of return and Rm is expected market return.
• It can also be calculated with the help of dividend model; Ke = (D1 / P0) + g

Cost of Capital = Cost of equity + Cost of debt

Weighted average cost of capital (WACC) = (Cost of equity * % of Equity in the firm) + (Cost of debt * % of debt in the firm)