1. Debt and Equity Financing
Cost of Debt and Equity
Prepared by Kumail Raza 1

2. Cost of Debt
• Example of Debt Financing
• Debt: Jones Industries borrows $600,000 for
10 years with an annual payment of $100,000.
What is the expected interest rate (cost of
debt)?
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3. Cost of Debt
Solution:
• Borrowing 600,000
• Period 10 years
• Yearly payments 100,000
• Expected Interest rate(EPR) To be calculated
(Cost of Debt)
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4. Cost of Debt
• The expected rate of return is the "annualized
effective compounded rate” that makes the
net present value of all cash flows (both
positive and negative) from a particular
investment equal to zero.
• NPV = NET*1/(1+EPR)^year
• In this case it is 10.56%
Prepared by Kumail Raza 4

5. Cost of Debt
Time period (Years) Dates
Cash inflows and
outflows
01/01/2012 (600,000)
1 12/31/2012 100,000
2 12/31/2013 100,000
3 12/31/2014 100,000
4 12/31/2015 100,000
5 12/31/2016 100,000
6 12/31/2017 100,000
7 12/31/2018 100,000
8 12/31/2019 100,000
9 12/31/2020 100,000
10 12/31/2021 100,000
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6. Cost of Debt
Formula for calculation of Present Value Present values of Cash inflows and outflows
(600,000)
100,000((1+10.56%)^-1) 90,450
100,000((1+10.56%)^-2) 81,813
100,000((1+10.56%)^-3) 74,000
100,000((1+10.56%)^-4) 66,933
100,000((1+10.56%)^-5) 60,541
100,000((1+10.56%)^-6) 54,759
100,000((1+10.56%)^-7) 49,530
100,000((1+10.56%)^-8) 44,800
100,000((1+10.56%)^-9) 40,522
100,000((1+10.56%)^-10) 36,652
Total (0)
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7. Cost of Equity
• Example of Equity Financing:
• Internal common stock: Jones Industries has a
beta of 1.39. The risk-free rate as measured by
the rate on short-term US Treasury bill is 3
percent, and the expected return on the
overall market is 12 percent. Determine the
expected rate of return on Jones’s stock (cost
of equity). Here are the details:
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8. Cost of Equity
Jones Total Assets $2,000,000
Long- & short-term debt $600,000
Common internal stock equity $400,000
New common stock equity $1,000,000
Total liabilities & equity $2,000,000
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9. Cost of Equity
• Formula for Cost of Equity
• Cost of equity = Risk free rate of return + Beta
x
where;
• Beta= sensitivity to movements in the relevant
market.
• X=market rate of return- risk free rate of
return
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10. Cost of Equity
• Beta 1.39
• Risk free rate of return 3%
• Market expected rate of return 12%
• X (12%-3%) 9%
Cost of equity = 3% + (1.39 * (12% - 3%))
=15.51%
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11. Weighted Average Cost of Capital
(WACC)
• WACC weights the cost of equity and the cost
of debt by the percentage of each used in a
firm’s capital structure
• WACC=(E/ V) x RE + (D/ V) x RD x (1-TC)
– (E/V)= Equity % of total value
– RE= Return on equity %
– (D/V)= Debt % of total value
– RD = Return on debt %
– (1-Tc)*= After-tax %
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12. Weighted Average Cost of Capital
(WACC)
• WACC=(1,400,000/2,000,000) x 15.51% +
(6,00,000/2,000,000) x 10.56% x (1 - 15%)
• WACC= 13.55%
Prepared by Kumail Raza 12