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The Cost of Debt & Preferred Stock

The Cost of Debt & Preferred Stock
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  • 0:00 Capital Structure
  • 1:00 Debt
  • 2:51 Preferred Stock
  • 3:44 Lesson Summary
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Lesson Transcript
Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, we'll define debt and preferred stock. You'll learn about the two types of debt and associated costs. We'll also discuss the costs of issuing preferred stock.

Capital Structure

Jose was named Entrepreneur of the Year by a top accounting firm for creating a widget that interfaces with the Internet, increasing upload and download speeds. A Fortune 500 company contacted Jose with interest in ordering 10,000 widgets by the end of the year.

While Jose's company is a medium-sized incorporated business, the company simply does not have enough capital to manufacture 10,000 widgets. Capital is money, or the availability of financing, for a company. Jose contacts his friend Eduardo, a business consultant, to assist in understanding his options to obtain capital.

Eduardo explains to Jose he has two options to finance the project, either with debt or preferred stock. Debt is where a creditor loans the company money with expectations of repayment. In the case of preferred stock, investors own a percentage of the corporation and are guaranteed payments called dividends. Both have advantages and costs. Let's take a closer look.

Debt

There are two types of debt: loans and bonds. A company that finances with loans completes an application with a financial institution, such as a bank or credit union. The institution reviews the company's information to determine risk associated with loaning the company money. If a bank approves the loan, they apply an interest rate, which is a fee to borrow money.

Jose asks Eduardo to explain further since he's still confused on how interest is applied. Eduardo uses an example of Jose's company borrowing $100,000 for this project. The $100,000 is the principal, which is the amount requested. The interest rate is 6%, and the length of the loan is five years, which yields a monthly payment of $1,933. Interest is a primary cost of obtaining money through a loan.

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