The after-tax cost of new debt and the cost of common equity are components of a company’s cost of capital, which is the percentage cost it incurs to use various sources of money in its business. A company’s after-tax cost of issuing new debt accounts for the tax deductions the company receives from making interest payments on its debt. A company’s cost of new common equity, or stock, accounts for the fees it incurs when issuing stock to the public. A company with lower costs of debt and equity has greater flexibility to invest in projects and greater profit potential.
After-Tax Cost of New Debt
Find a company’s corporate tax rate and credit rating in its annual report. A company’s credit rating contains one to three letters, such as B or BBB. AAA is the highest credit rating and represents the lowest company risk and lowest cost of debt, while a C or D represents higher risk. For example, assume the company has an AA credit rating and a 35 percent corporate tax rate.
Find the current yield of 10-year corporate bonds with the same credit rating as the company on any financial website that provides stock and bond information. This is an estimate of the interest rate a company would have to pay if it issued new debt. For example, assume 10-year AA corporate bonds have a 5 percent yield.
Subtract the company’s corporate tax rate from 1. For example, subtract 35 percent, or 0.35, from 1, which equals 0.65.
Multiply your result by the rate the company would need to pay if it issued new debt to determine the company’s after-tax cost of new debt. For example, multiply 0.65 by 5 percent, or 0.05, which equals 0.033. This is equivalent to a 3.3 percent after-tax cost of new debt.
Cost of Common Equity
Find the amount of a company’s expected annual dividend payment per share of common stock over the next year and the company’s current stock price on any financial website that provides stock information. For example, assume the company will pay $1.50 per share in dividends over the next year and the current stock price is $50.
Estimate the annual percentage rate you expect the company’s dividend payment to grow in future years. For example, assume the company will grow its dividends at 5 percent per year in future years.
Subtract the estimated percentage flotation cost for the company to issue new stock from 1. The percentage flotation cost consists of fees and commissions a company incurs to issue new stock to the public. For example, assume the company would have to pay 15 percent in flotation costs. Subtract 15 percent, or 0.15, from 1, which equals 0.85.
Multiply your result by the stock price. For example, multiply 0.85 by $50, which equals $42.50.
Divide next year’s dividend by your result. For example, divide $1.50 by $42.50, which equals 0.035.
Add the dividend growth rate to your result to calculate the cost of new common equity. For example, add the dividend growth rate of 5 percent, or 0.05, to 0.035. This equals 0.085, which is equivalent to an 8.5 percent cost of new common equity.