The cost of debt is the effective interest rate that a company pays on its debts, such as

bonds and loans.

Let’s take a look at the formulas used to calculate the cost of debt:
Debt Issued at Par is given as follows:

Where,
kd = Before-tax cost of debt or the rate of return required by lenders
I = Coupon rate of interest
B0 = Issue price of the bond (debt)
INT = Amount of interest

Debt Issued at Discount or Premium is given as follows:

Where,
kd = Before-tax cost of debt or the rate of return required by lenders
B0 = Value of borrowing or debt or bond/debenture today (Cost of debt)
Bn= Repayment value of debt on maturity
INT = Amount of interest

After-tax Cost of Debt is given as follows:

© Copyright upGrad Education Pvt. Ltd. All rights reserved

After-tax cost of debt = kd (1-T)

A debt covenant is a restriction placed by the lender on the company, which restricts
certain company actions. They are legally binding agreements that are included as part of
the lending contract. Commercial banks use different types of debt covenants to reduce
the risks on their loans. Some examples of debt covenants are listed below.

Violation of Debt Covenants

Under the terms of lending agreement, a financial institution will have potential remedies
if one of the restrictions is violated. The lender could:

© Copyright upGrad Education Pvt. Ltd. All rights reserved

The cost of equity is the compensation that investors demand in exchange for investing
equity in the business. The cost can be further divided into two types.

Cost of Common Share Equity

The cost of equity is calculated by rearranging the dividend discount model.

The formula for the dividend discount model is:

© Copyright upGrad Education Pvt. Ltd. All rights reserved

This formula is rearranged to calculate the cost of equity:

Where,
PE = Share Price
Div1 = Next year’s dividend
re = Cost of equity
g = Dividend growth rate

Cost of Preference Stock Equity

The key difference between common stock and preference stock is that the holders of
preference stock are promised a fixed dividend.

The formula used to calculate preference stock is almost the same as that used for
common stock but with a slight change, as preference shares have a fixed dividend. The
growth rate is 0. So, the formula for cost of equity becomes:

Where,
Pp = Current price of preference shares
Divp = Fixed dividend

rp = Preference stock cost of equity

g = Dividend growth rate

© Copyright upGrad Education Pvt. Ltd. All rights reserved

Weighted average cost of capital (WACC) is the average of the cost of debt and the cost of
capital weighted by the proportion of debt and equity. The following three components
are used to calculate the WACC:
● Cost of debt
● Cost of common share equity
● Cost of preference share equity

The formula to calculate WACC is as follows:

Weighted Average Cost of Capital (WACC) = (Cost of Debt × Weightage of Debt) + (Cost
of Equity × Weightage of Equity)
Or

Where,
re × E% = Cost of common equity times the proportion of common equity
rp × P% = Cost of preference equity times the proportion of preference equity
rdt × D% = Effective cost of debt times the proportion of debt
Rwacc = Average cost of capital

The optimal capital mix of a company refers to the best combination of debt and equity
financing that will maximise its value. Given below are the key factors that you need to
consider before finalising the debt to equity ratio for the project.

© Copyright upGrad Education Pvt. Ltd. All rights reserved

Disclaimer: All content and material on the upGrad website is copyrighted material,
belonging to either upGrad or its bona fide contributors, and is purely for the
dissemination of education. You are permitted to access, print, and download extracts
from this site purely for your own education only and on the following basis:
● You can download this document from the website for self-use only.
● Any copies of this document, in part or full, saved to disc or to any other storage
medium, may be used for subsequent, self-viewing purposes or to print an
individual extract or copy for non-commercial personal use only.
● Any further dissemination, distribution, reproduction, and copying of the content
of the document herein, or the uploading thereof on other websites, or use of the
content for any other commercial/unauthorized purposes in any way that could
infringe the intellectual property rights of upGrad or its contributors is strictly
prohibited.
● No graphics, images, or photographs from any accompanying text in this document
will be used separately for unauthorized purposes.
● No material in this document will be modified, adapted, or altered in any way.

© Copyright upGrad Education Pvt. Ltd. All rights reserved

● No part of this document or upGrad content may be reproduced or stored on any
other website or included in any public or private electronic retrieval system or
service without upGrad’s prior written permission.
● Any rights not expressly granted in these terms are reserved.

© Copyright upGrad Education Pvt. Ltd. All rights reserved