 Each component of capital has a cost different from other components of the capital due to differences among the component of capital. So the cost of each component needs to be determined accordingly. The first component we have is the debt. The cost of debt means the cost of debt financing to a company who uses a debt issue, a bond issue or a bank loan. The cost of debt can be determined using two approaches. The first is yield to maturity or YTM and the second is the debt rating. YTM or yield to maturity is the annual rate of return earned by an investor while holding a bond till its maturity. In fact, the YTM equates the present value of a bond with its current market price. If we see the model, we can see that there are two parts. The first part is basically determining the present value of the annual cash inflows which are the interest on the bond. And the second element is determining the present value of the face value of the bond. Now when we sum up the present value of future cash flows on interest payments and present value of face value of the bond, the total present value should be equal to the current price of the bond and at a rate at which these two prices are equal to the current price of the bond is known as yield to maturity or YTM. This equation we are using a semi-annual compounding. Now this compounding may be monthly, may be quarterly or it may be annually. So we have to amend our model accordingly. On the screen, we can see an example that how to determine cost of debt. We have a 10 year, 5% semi-annual open bond whose market price is $1,225. Tax rate is 35%. Now we need to determine the cost of debt before tax and after tax using this data. And we see the solution we have, the present value are which is basically the current market price of the bond. We have face value. We have payment plan of interest payments that is 5% of 1000. And as we have semi-annual compounding, so we have $25 for each half year period. And we have 5 years life of the bond. So total number of period will be 20. Putting our values into the model. We have a YTM equal 2.342 or 2.34%. That is the before tax cost of debt. And when we apply the tax rate to this after converting it into annual rate which is 4.68%, then the annual YTM comes to 3.045 or 3.05%. That is the annual YTM on this bond and this 3.045 or 3.05% is basically the cost of debt on this debt instrument. The second approach that can be used to determine the cost of debt is the debt-treating approach. And in fact, debt-treating approach is used where the company does not have current market price of its debt. How this approach works? In fact, in this approach, we use the yield on comparable rated bonds of the comparable companies for the maturities that are closely matched to the company's existing debt. There is one thing that needs to be considered that debt-treatings are basically the ratings allocated to a particular debt instrument. These are not the ratings allocated to the company as a whole. In the bond market, determining cost of debt through this method is generally termed as matrix pricing. There are certain issues that a financial analyst can face while determining the cost of debt. The first issue is the fixed or floating rate debt. When a company has fixed rate debt, then the market yield of the company's existing debt or debt of similar risk can be used as cost of debt. And if the company has a floating rate debt, then it is better to use current term structure of the interest rate to willing in the economy through using the term structure theories. Now, what is the floating rate debt? In fact, floating rate debt is the debt whose interest rate is adjusted periodically in line with a prescribed index like Kaibor in Pakistan. And this adjustment is done to the debt instrument throughout its life. There is another issue. If the debt instrument has certain option-like features, then what to do? For the outstanding debt with option-like features with the potential of some issuance of any instrument in the future, then it is better to use yield to maturity to determine cost of debt on this debt instrument. And if the company is believed to aid or remove any option feature in the future, then it is better to use market value adjustment to the current YTM of the company's existing debt. But if the company has no rated debt, a company might not have any debt outstanding or the company might not have yield on its existing debt, or the company may not have its bond rated by any particular rating agency. Then in that particular case, it is better to use synthetic debt rating based on the financial ratios. This means that certain financial ratios of that particular company can be computed in order to determine the cost of debt of that particular company. And in fact, this is very imprecise method because it is unable to incorporate information about the particular debt issue and the issuer in order to determine the cost of debt. The third issue that an analyst faces is the leasing. To determine the cost of debt in a leasing contract, the procedure that can be applied is similar to the procedure that can be used for a long-term borrowing. The second component of capital is the preferred stock. Now, how to determine the cost of a preferred stock? The cost of a preferred stock we mean is the cost a company promises to pay its preferred shareholders as preferred dividend. And this dividend is paid at a fixed and guaranteed rate throughout the life of the preferred share or preferred stock to its holder. For non-convertible, non-calable preferred stock with fixed dividend rate and no maturity date means that on such type of preferred stock, the dividend payment will go in perpetuity. And to determine the cost of such preferred stock, we can divide its dividend over its dividend rate means the amount of dividend can be divided over the dividend rate. The resulting figure is basically the current market price of the share. Now, we have three variables in this model, the current market price, dividend amount and the dividend rate or the, in fact, it is the cost of preferred stock that is RP. Now, to determine RP in this model, we rearrange this model in the sense that we divide the dividend over the market price of the share over the preferred share. And the resulting figure is the cost of preferred stock or RP. In fact, unlike the debt, there are no tax adjustments while determining the cost of preferred stock because the dividend on preferred stock is not allowed by tax authorities as an admissible expense.