Estimating Cost of Mezzanine Capital

Abstract

Purpose of the article: There are more kinds of used financial sources and the chargeable of them are termed as capital. They can can be divided into two basic groups according to the legal position of the provider, namely into equity and debt. Each item of capital is connected with some costs because of the existence of risk. There is generally known, that owners bear a higher rate of risk than creditors, thus the cost of equity should be higher than cost of debt. But there are also differences in risk rates within each group of capital, because there are more kinds of equity and debt. So the cost of every item of equity and debt should be estimated differently. Furthermore, there is used a mezzanine capital, which has some characteristics of both equity and debt. Methodology/methods: There is implemented a secondary research based on studying existing literature dedicated to either kinds of capital, including the mezzanine capital, or cost of capital. The existing theory about estimating cost of equity and debt is consequently applied on individual types of mezzanine capital. Scientific aim: This article has its aim to estimate cost of mezzanine capital, which can be used in three basic forms, namely senior subordinated debt, convertible subordinated debt or redeemable preferred stock. To fulfill this aim, there is used the theory of estimating cost of common and preferred stock and the theory of options. Findings: The providers of senior subordinated debt bear a higher risk than other “classical” creditors, which is analogous to holders of common and preferred stock. So the difference between cost of these two kinds of debt (before interest tax shield) should be the same as the difference between cost of common and preferred stock. By estimating cost of convertible subordinated debt can be used the theory of options. So the convertible subordinated debt is divided into two parts, debt itself and the call option, whose cost is estimated as cost of equity. Costs of both parts are added up. Cost of redeemable preferred stock is estimated by using the theory of options, too. But in this case, the holder of preferred stock is in the short position, which means, that cost of this option is subtracted from the cost of preferred stock itself. Conclusions: Cost of any types of mezzanine capital is higher than cost of debt, but lower than cost of equity, which is related to the rate of risk. Furthermore, cost of senior subordinated debt is lower than cost of convertible subordinated debt and cost of this type of mezzanine capital is lower than cost of redeemable preferred stock, because of different rates of risk, too. So using mezzanine capital can significantly affect the capital structure and the weighted average cost of capital.