Please provide a narrative on the applying the costs of debt and equity to stock and...

Please provide a narrative on the applying the costs of debt and equity to stock and bond valuation.

Expert Solution

Cost of debt and cost of equity are a very important factor for valuing stock or bond

For Valuing Stock:

Stocks are valued by various methods one of them is absolute valuation or Discounted Cash Flow Valuation (DCF). In DCF valuation the cashflows of the business are discounted by the discount rate which is generally the cost of capital.

Now the cost of capital arrives from both i.e costs of debt and cost of equity, generally called as WACC (Weighted Average Cost of Capital)

WACC is given by multiplying the cost of each capital by its relative weight in the mix.

WACC = (1-Tax%)*Cost of Debt* (D/D+E) + Cost of Equity(E/D+E)

For Valuing Bonds:

Bonds are valued by discounting the cash flow of the coupons and the final payment by the yield of maturity now the yield to maturity is determined at what coupon the bond is issued if the bond is issued. Coupon % depends upon how risky is the business and the use of money for which the bond is issued. This coupon % becomes one part of the cost of debt for the companies. There is no role of cost of equity in valuing the bond.

jeff jeffy answered 1 year ago

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