Question

Are the costs of debt and equity observable in the capital markets? If not, how do you estimate that cost of capital?

Answer 1

Depending on the supply and demand of equity, a bond’s price can vary, thus the premium or discount price.

For example, when the interest rate falls, older bonds may become valuable because they were sold in a higher interest rate environment and therefore with a higher coupon rate. Consequently, investors holding those bonds can commend a "premium" to sell equity. On the other hand, if the interest rate rises, older bonds may become less valuable. In order to get rid of them, investors may have to sell for less, thus the "discount” price.

Bond prices are quoted as a percent of the bond’s face value, and an easy way to learn the price of a bond is simply by adding a zero to the price quoted. For instance, when you hear a bond is quoted at 99, it means the price for the bond is $990 for every $1,000 of face value. Because the bond price is below the face value, it’s said the bond is traded at a discount. On the other hand, if the bond is trading at 101, it means you will pay $1,010 to get that $1,000 face value bond.

The dividend discount model (DDM) is a procedure for valuing the price of a stock by using the predicted dividends and discounting them back to the present value. If the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued.

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